Dear Carrie: I’ve heard people talk about balancing out their capital gains with capital losses before the end of the year, but I’m not sure how that works. Can you explain? — A Reader
Dear Reader: This is a great question and a perfect time to be asking it. It’s always smart to review and rebalance your portfolio at year-end to make sure your asset allocation is still on target. It’s also a good time to consider harvesting some capital losses. By doing so, you may ultimately be able to trim your losses and your taxes — as long as you complete any sales by the end of the year.
So before your holiday to-do list gets too overwhelming, take the time to review your investments — both winners and losers — to see if balancing capital gains and losses could lower your tax bill. It’s not a difficult process, but it does take some careful calculations. Here’s a step-by-step guide and an example to help you get started.
Categorize Your Investments as Either Short-Term or Long-Term
For tax purposes, investments are considered either short-term or long-term. A short-term investment is one that you’ve held for one year or less. A long-term investment is one that you’ve held for more than a year.
This time difference is important because realized gains on short-term holdings are taxed at your ordinary income tax rate. Gains on long-term holdings are taxed at a much lower rate — from zero to 20 percent depending on your tax bracket.
Calculate Your Long- and Short-Term Gains and Losses
Of course, you only realize a capital gain (or loss) when you sell an investment in a taxable account. But once you decide what to sell, you’ll want to carefully calculate your estimated gains and losses. That’s because you can use up to $3,000 of losses to offset any gains in a particular year to potentially bring your tax bill down. Any losses above the $3,000 may be carried forward indefinitely to offset gains in future years.
Because both capital gains and capital losses are categorized as either short-term or long-term, depending on how long you’ve held the investment, almost every sale will create one of the following four results: a long-term capital gain, a long-term capital loss, a short-term capital gain, or a short-term capital loss.
How these net out will determine if you ultimately have a capital gain or loss, and what kind.
Net Out Your Gains and Losses to Come up With a Single Number
This is a three-step process:
–Net your LTCGs against your LTCLs.
–Net your STCGs against your STCLs.
–Net your long-term result against your short-term result to come up with a single taxable figure.
Here’s an example of how this works: This year Sam decided to sell several investments in his taxable account. His sale of long-term investments resulted in a LTCG of $11,000 and a LTCL of $6,000, which netted out to a LTCG of $5,000. He also made short-term sales that resulted in a STCG of $5,000 and a STCL of $6,000, which netted out to a STCL of $1,000.
Sam was then able to net out his capital gains and losses — $5000 in long-term gains against $1,000 in short-term losses — to come up with a $4,000 long-term capital gain. This provides a valuable benefit for Sam because he was able to make the sales he wanted, lower his capital gains, and end up paying only the lower long-term capital gains tax rate.
If Sam had ended up with a net capital loss, he’d be able to deduct up to $3,000 against his ordinary income and carry over any remainder as a deduction in future years. Either way, he’s ahead in terms of taxes.
Watch Out for the Wash-Sale Rule
Sometimes it can make sense to sell a stock or mutual fund to take a tax loss, even if you think it’s ultimately a keeper and figure you’ll buy it back at a future date. It seems like a smart move, but watch out for the wash-sale rule. If you sell a security at a loss, and buy the same or a “substantially identical” security within 30 days, the loss is generally disallowed for tax purposes. The IRS doesn’t miss a trick!
Be Sure to Specify Shares on a Partial Sale
Here’s another potential catch. When you sell, your broker is required to report the cost basis for stocks purchased after Jan. 1, 2011. When you make a partial sale, the default method is FIFO, or “first in, first out.” FIFO may not be the most tax-efficient method, however, especially if you bought additional shares later at a higher cost. But you do have the option to specify which shares you want to sell, so if you’ve purchased shares of the same investment at different prices, you may be able to lower capital gains and minimize taxes by selling shares with a higher cost basis.
This year-end maneuver can potentially make a difference in your tax bill, but don’t let it cloud your long-term perspective. Always keep your goals and your asset allocation top of mind as you consider what and when to buy and sell. To me, that’s the real key to smart investing.
Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER ™ is president of the Charles Schwab Foundation and author of “It Pays to Talk.” You can e-mail Carrie at firstname.lastname@example.org.