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Tax Planning for Investments
Don’t overlook the tax consequences when figuring the return on your investments. Taxes are a vital part of any investment…
Don’t overlook the tax consequences when figuring the return on your investments.
Taxes are a vital part of any investment decision. But remember that taxes are only a part of an overall investment strategy. Financial advisers recommend that you make investment choices not solely on tax avoidance—but on what you can expect to earn, the level of risk you’re willing to take, and the diversification of your portfolio.
CAPITAL GAINS
A capital asset is any property you can buy or sell. That includes securities, your home and other real estate, jewelry, cars, and collectibles. A capital gain is your profit when you sell an asset for more than it cost you. You have a capital loss, on the other hand, if you sell the asset for less than it cost.
Capital gains are usually taxable. Capital losses are deductible only if you’ve held the item for investment and not for personal use. So you’ll need complete records for all of your transactions and expenses. See IRS Publication 550, “Investment Income and Expenses,” for the details. You can download or view a copy at the IRS website, www.irs.gov.
LONG- AND SHORT-TERM GAINS
If you hold an asset for 12 months or less, any increase or appreciation in its value will result in a short-term gain. These gains are taxed as ordinary income, at your regular tax rate. But if you own an asset for more than a year before you sell at a profit, you have a long-term capital gain. Those gains are taxed at a maximum rate of 15% for most taxpayers, but 20% for those in the highest income bracket. If your regular tax rate is 10% or 15%, long-term capital gains are taxed at 0%.
You could owe a net investment income tax of 3.8% as a Medicare contribution surtax, plus an additional 0.9% tax, if your modified adjusted gross income (MAGI) is more than $200,000 and you’re a single tax filer or more than $250,000 if you’re married and file jointly.
DEDUCTING CAPITAL LOSSES
If you lose money on an investment, you may be able to deduct your losses. You can combine your capital gains and capital losses to offset, or reduce, the gains on which you owe tax. Or you may wipe out all your gains and have a net loss.
If you have a net loss, you may use it to reduce your taxable income, but there’s a cap of $3,000 per year. If your loss is greater than that amount, you can carry over the excess and deduct it in later years.
Specific rules apply to figuring losses on investments you receive as gifts. You may want to consult your tax adviser to be sure you report them correctly.
Holding stocks defers capital gains taxes: while you’re holding an investment, you don’t pay tax on any increase in value. The market price of a stock you bought for $5 a share may climb to $50, but the tax on that capital gain is deferred until you sell the stock and collect the proceeds. If you sell when you’ve held stock for more than a year, you owe tax at the capital gains rate, which is always lower than your ordinary income tax rate.
For this reason, you might pick stocks for their long-term growth potential as well as for regular dividends they might pay. You pay tax on most dividends as they are paid, at your long-term capital gains tax rate.
PASSIVE INCOME
Passive income or losses come from businesses in which you aren’t an active participant. These include limited partnerships, rental real estate, and other business ventures that you don’t help manage.
Losses from passive investments may be used to offset only income from similar ventures. The losses cannot shelter other income. That is, they can’t be used to offset active income, such as wages and salaries, or portfolio income, such as interest, dividends, and capital gains. Losses you can’t use may be deducted only when the passive investment is sold or disposed of in a taxable transaction. A gift is not a taxable transaction.
RETIREMENT INCOME
You’ll also want to plan ahead so that when you begin to take income from your retirement accounts you’ll be able to keep your taxes as low as possible.
One factor, of course, is that once you reach 72, you’ll have to take annual required minimum distributions (RMDs) from your tax deferred employer plans and IRAs, and these amounts are fully taxable. If you have large account balances, you may want to ask your financial adviser about managing your withdrawals to spread out the tax burden.
However, if you’ve contributed to a Roth account or rolled over assets to a Roth IRA, you can take tax-free withdrawals at any time. Interest on municipal bonds is tax free as well. And, if qualified dividends and distributions make up a portion of your retirement income, at least that portion will be taxed at a lower rate than your ordinary income.
THE GAIN OF GIVING
If you donate appreciated property, such as stock or a house that you’ve held for over a year, to a recognized charitable organization, you may deduct the market value and avoid capital gains tax on the appreciation. If a stock’s value has dropped, you can sell it, take the capital loss and donate the proceeds of the sale.
However, all appreciated property may not be equal in the eyes of your beneficiary. While publicly traded securities are generally welcome, assets that can’t be converted easily to cash or require expensive maintenance may not be.
FIGURING GAIN
You figure gain or loss by subtracting your basis from the proceeds of a sale. Basis is the price paid for the item, plus the expense of buying, holding, and selling it. For example, the commissions and costs of an investment transaction are subtracted from the proceeds of a sale when you figure a gain or loss. If you received the item as a gift, your basis is the same as the giver’s was. If you inherit an asset, your basis is the market value on the date of the giver’s death. See IRS Publication 551, “Basis of Assets.”
PROCEEDS The amount you get when you sell your asset
− BASIS The original cost of the asset, plus the cost of buying, holding, and selling it
= GAIN or LOSS Until seven years after you sell
Here’s how you would figure a capital gain:
$22,000 Gross proceeds from the sale of stock
− 20,000 Amount you paid for the stock
− 385 Broker’s commission and fees on sale
= $1,615 Your capital gain