Tax planning and compliance for investors
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Basic planning techniques for capital gains and losses.
One nice thing about capital gains and losses is that you have some control over them. You can sell your stock now or later, depending on which choice produces better tax results. You can choose which stock to sell and even choose which shares of that stock to sell if you bought shares at different times or different prices. Choose intelligently and you can reduce your tax bite.
We aren't suggesting that tax considerations should control your choices. Tax considerations should influence your investment strategy, not control it. If you have a good tax idea that's a bad investment idea, chances are it's not such a good idea.
And bear in mind that one tax idea may be in conflict with another one. For example, you may have a choice between selling a stock with a large, long-term gain or another stock with a small, short-term gain. Generally you want to avoid taking the larger gains — but you also want to avoid taking short-term gains. There's no rule of thumb that tells you which tax goal should prevail. You need to do what makes sense in light of the overall situation.
You'll pay less tax if you sell shares that have smaller gains (or larger losses). That point may seem almost too obvious to mention when you're comparing two different stocks. But some people need to be reminded that this is also true if you have shares of the same stock that you bought at different prices. If you want to sell specific shares other than the earliest ones you bought, you should read our Guide to Identifying Shares.
That's a boring word for a mundane concept: other things being equal, it's better to pay taxes later rather than sooner. So the most basic planning technique for capital gains is simply to avoid selling your gains. Delay until next year and, if possible, until the year after that. The sooner you sell, the sooner Uncle Sam takes his bite.
As it happens, this bit of tax strategy is consistent with one of the most successful investing strategies: buy and hold. You save on taxes, you save on brokerage commissions, and if you're holding good quality stocks you're building wealth. Tough to beat that combination.
Here's another reason for patience: hold your stocks long enough and the gains will be taxed at a lower rate. You need to hold an asset more than a year to qualify for the 15% rate (5% for gain that falls in the 10% or 15% bracket). So keep track of your purchase dates and avoid selling stock with gains before you qualify for the lower rate.
This tax advice goes against the grain of the buy-and-hold theory. In some cases you're better off if you sell your losers before they turn long-term. Generally this is true only if you have both long-term and short-term capital gains.
Example: During the current year you have $2,000 of short-term capital gain and $2,000 of long-term capital gain. You also have a stock that has gone down in value by $2,000, and you plan to sell it and report a capital loss. If you sell when the loss is short-term, the loss will zero out your short-term capital gain, which is taxed at the same rate as ordinary income. If you wait until the loss is long-term, the loss will zero out your long-term gain, which would otherwise be taxed at a favorable rate.
If you have large capital losses and capital gains, it can be helpful if they fall in the same year. That way you don't have a big hit of income — and tax — in one year. You especially want to avoid having your large losses fall in a year after your large gains, because losses carry forward but not back. Remember that you can only deduct $3,000 of capital loss in excess of capital gain.
Example: One year you have $20,000 of capital gain and no capital loss, so you have to pay tax on the entire capital gain of $20,000. The next year you have $20,000 of capital loss but no capital gain. You can only deduct $3,000 of the capital loss. The rest carries forward to the next year. Depending on your future capital gains, it may take several years before you can use the entire $20,000 capital loss. If the loss fell in the same year you had the big gain, you would have received the benefit immediately.
Except when you're trying to soak up a big capital loss, you generally want your long-term gains to fall in years when you don't have capital losses (short-term losses or long-term losses). Isolating your long-term gains in this way will maximize your use of the favorable rates on long-term gains.
Example: During 2003 you have $3,000 of capital loss (it doesn't matter whether it's short-term or long-term). You also have a $3,000 long-term gain you can take in 2003 or hold until 2004. If you postpone the gain until 2004, your 2003 loss will reduce your tax on ordinary income (wages, interest or dividends, for example), and your gain will be taxed the following year at the favorable rate for long-term capital gain. But if you take your capital gain in 2003 it will swallow up the capital loss and you won't get the benefit of the favorable capital gain rate.
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