Earnings is all about how much you keep after taxes – not what you bring in from your job, a business, or investments. While it is always great to see fabulous investment gains, the only financial metric that really matters is what is in your bank account at the end of the day. One of the ways you can influence this is by minimizing the taxes you pay on your investments.
Unfortunately, many people do not think about how taxes impact their investment returns until near the end of the year; however, you should act all year round. Taking part in investment tax planning throughout the year will give you opportunities to keep more of what you earn. Here are some rules and strategies to keep in mind.
Know When to Take Your Losses
Psychologically, many investors are averse to taking losses, holding out to “make their money back.” Instead of emotion, logic and investment acumen needs to be applied here. If an investment does not have a fundamental reason to turn around, then you are better off selling it and taking a tax loss.
Losses reduce taxes on either your capital gains for the year or, when losses exceed gains, up to $3,000 on other income. Excess losses can be carried forward to future years. Plus, you will have the proceeds to reinvest in something more likely to produce a return.
Let Winners Run
Unlike long-term capital gains, short-term capital gains are taxed as ordinary income. This means your marginal income tax rate (the highest rate applied to you) can impact your investment gains.
While you should not let the tax tail wag the investment dog, ideally you want to hold a winning investment for at least a year and a day to benefit from long-term capital gains tax treatment. This means you will pay only a 20 percent maximum tax versus whatever your marginal rate is.
As with losses, the fundamentals of the investment are key. Therefore you should not sell a holding if you think the gains are at risk just to save on taxes. If you believe in the investment for the long term, then holding out for preferred capital gains treatment can be a clever idea.
Give the Gift of Appreciation
Making charitable donations you would not otherwise give is generally not a viable tax strategy. However, if you are already charitably inclined, then consider donating stock or mutual funds instead of cash.
When you donate property such as stocks, your charitable deduction is based on the fair market value of the asset on the date of the gift. It is much better to do this than donate cash.
For example, if you have a stock you purchased for $35 and it is now worth $135 when you donate it you will receive a charitable deduction of $135. If you were to sell the stock first, you would have to pay tax on the $100 gains and then have only $103 to donate in cash – assuming you are in the 32 percent tax bracket. The only winner in this situation is the IRS; both you and the charity lose. This is because the charity is excluded from paying capital gains taxes on the appreciation that occurred while you owned the asset.
Hold Until You Die
This strategy does not benefit you directly, but rather your heirs. When someone inherits an asset such as real estate, stocks, bonds, mutual funds, etc., the cost basis of the asset is reset to the fair market value at the date of death.
This means that if you have stock in company XYZ that you bought for $50 and now it is worth $500, you would pay tax on the gain of $450 per share. However, your heir would pay $0 if he sold it on the day you died. If your beneficiary continues to hold the stock, the benefit still applies as his cost basis in the stock of XYZ would reset to $500, so he will pay taxes only on gains over that amount.
While you should never cheat on your taxes or do anything unethical, it is foolish to pay any more than is legally necessary to the IRS. Engage in investment tax planning year-round and you may see better after-tax returns and more money in your bank account.