Market downturns, like the one in October, are a good time to adjust your fund portfolio to minimize the tax bite. Here’s how to calculate the best ways to do that – now and in the future.
Taxable accounts you hold longer than a year incur long-term capital gains taxes when you sell investments. You realize losses or gains, meaning your losses are subtracted from the gains and, if the result is positive, your gains are taxed at the preferable long-term capital gains rates (a rate often much less than ordinary income tax rates).
The rates range from 0% to 15%. You receive the 0% rate if your ordinary income tax bracket is 10% or 15%, meaning your annual taxable income is less than $73,800 if you file your return using the married filing jointly category (MFJ) and below $36,900 if you file as single. Above these thresholds, your capital gains incur the 15% rate.
Trimming taxes. When your losses exceed your gains, your capital gains are netted against the losses and the losses subtracted from the gains. In this manner, your gains incur no tax. If your losses exceed gains, you can use the excess to reduce your ordinary income up to $3,000 per year, carrying over any remaining losses to future years.
Let’s say your four taxable accounts (A, B, C and D) each have a cost basis (what you paid for the fund originally) of $10,000.
- Fund A’s current value is $15,000 and it gained $5,000;
- Fund B’s current value is $20,000 and it gained $10,000;
- Fund C’s current value is $8,000 and it lost $2,000; and
- Fund D’s current value is $4,000 and it lost $6,000.
As is, you net a gain of $7,000 (your gains of $5,000 plus $10,000, minus your losses of $2,000 and $6,000).
You can sell various combinations of your funds’ holdings, though, for best tax advantage. Selling all of funds A (which had a gain of $5,000) and D (loss of $6,000) nets you a long-term capital loss of $1,000. If this is your only activity in long-term holdings for the year, you owe no capital gains and you realize $1,000 in losses to use to reduce your income.
What if you sell just 80% of your fund B, meaning $8,000 in gain? Then you sell all of both funds C and D, which combined lost $8,000? The result: zero capital gains and zero capital gains tax.
This last example is the least efficient way to use your losses. Always attempt to maximize the amount you can use against ordinary income, resulting in the greatest tax reduction. If you sell all of funds A, C and D, for instance, you get a capital loss of $3,000 ($5,000 minus $2,000 minus $6,000) that you can use to offset income this year and potentially in future years.
These strategies become even more important with larger holdings and if you have funds that rebound in value in the future.
Social Security and other tax issues. Be careful with your capital gains. For instance, a gain taxed at even the 0% rate can increase your adjusted gross income, in turn increasing taxes on your Social Security income.
Also use care after you sell a holding that recognized a loss. If you look to better your tax situation in the future with the same or a substantially similar asset, you need to wait at least 30 days before you buy. Otherwise you trigger what’s called a wash sale treatment, which according to the Internal Revenue Service effectively eliminating that loss for tax purposes.
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Jim Blankenship, CFP, EA, is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, Ill. He is the author of An IRA Owner’s Manual and A Social Security Owner’s Manual. His blog is Getting Your Financial Ducks In A Row, where he writes regularly about taxes, retirement savings and Social Security.
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