As the year progresses, thoughts of investors inevitably turn to taxes. Of course, in most cases investment factors will have more to do with the decisions you make than taxes will, but some of your investment moves indeed may be designed to improve your tax situation. After all, how much you pocket after taxes, not how much you earn from securities transactions, counts the most.
It’s probably a matter of routine for you to try to “harvest” capital losses, especially as the year winds down, to offset capital gains from stock sales realized earlier in the year. By and large, that still makes sense. But this year, the likelihood that tax rates soon will increase across the board adds another wrinkle that could make it important to fine-tune your tax-related investment strategies.
First, let’s look at the basics. For federal income-tax purposes, capital gains and losses are “netted” under the following rules at tax-return time: First, long-term gains and losses are separated from short-term gains and losses. A capital gain or loss is long term if you’ve held a security for more than one year before you sell it. For example, if you acquired stock on December 1, 2011, and you sell it at a profit on November 30, 2012, your gain is treated as a short term. But if you hold the stock just two days longer—until at least December 2—you qualify for long-term capital-gain treatment.
Then you place all of your long-term gains and long-term losses in one basket. This gives you either a net long-term gain or a net long-term loss. Next, you place your short-term gains and short-term losses in another basket—and end up with either a net short-term gain or a net short-term loss. Finally, you combine the net long-term gain or loss with the net short-term gain or loss to arrive at an overall net capital gain or loss.
If your capital gains exceed your losses, the maximum tax rate on any net long-term gain in 2012 is 15% for someone in a regular tax bracket of 25% or higher (0% for investors in the lower regular tax brackets). Conversely, if your capital losses exceed your gains, the net loss can be used to offset up to $3,000 of highly taxed ordinary income, such as your salary. If your loss is more than $3,000, you can carry the excess to future years. (Keep in mind, though, that under the “wash sale rule,” you can’t deduct a capital loss if you reacquire substantially identical securities within 30 days of a sale.)
Those are the basic ground rules and they haven’t changed. However, the usual tax harvesting of capital losses is complicated this year due to three pending tax law changes:
1. The maximum tax rate for net long-term capital gain is scheduled to increase to 20% in 2013 (10% for investors in the lower regular income brackets). Thus, there’s a powerful tax incentive to realize capital gains this year.
2. The ordinary income-tax rates also are scheduled to go up in 2013. The current top tax rates of 33% and 35% will be bumped up to 36% and 39.6%, respectively, and rates for lower brackets also will increase.
3. Beginning in 2013, an additional 3.8% Medicare surtax will apply to the lesser of your net investment income for the year or the amount by which your modified adjusted gross income (MAGI) exceeds $250,000 ($200,000 for single filers).
These tax increases are, of course, subject to change if Congress acts. However, as things stand now, a high-income investor could be looking at an effective tax rate of 23.8% percent on long-term capital gains. And the tax rate for short-term gains could be as high as 43.4%!
Knowing what’s ahead, you may be able to devise investment strategies that maximize the potential tax benefits of the situation. For instance, if it makes sense from an investment point of view, you may want to harvest tax losses soon enough to have them qualify as short term—so that they offset short-term rather than long-term gains. That way, you won’t negate any of the preferential tax treatment of long-term gains.
On the flip side, if you’re in a position to take capital gains, you should realize short-term gains to offset long-term losses. Once again, you don’t want to waste the benefit of paying a maximum tax rate of only 15% on your long-term gains this year. Unlike in most other years, you might emphasize harvesting gains instead of losses in 2012.
Naturally, these investment moves can’t be made in a vacuum. But this should give you considerable food for thought. The best approach is to develop a logical plan, with our assistance.