Capital losses can help cut your tax bill
Timing is everything
While many factors will affect your choice to sell a security, tax considerations can be a major component of such a decision.
- Capital losses are best taken in a year with short-term capital gains or no gains, because you will save on your full ordinary income tax rate. The tax consequences of a short-term capital gain can send you looking for a devalued stock to purge from your portfolio. Dump the losers; enjoy the tax break.
- Long-term capital gains have an attractive low tax rate (15 percent for most investors), so the benefit of a deductible loss is much less.
The current capital gains rates will remain in place through 2012. Beginning in 2013, higher income taxpayers will pay a top capital gains tax rate of 20 percent.
Tax rate considerations
Tax rates also matter when it comes to losses. If you are in the 10 percent or 15 percent brackets, you won't owe any capital gains taxes on assets sold for a profit.
Individuals who might benefit from this zero capital gains rate include retirees or folks who've reduced their work schedule as they near retirement, and young workers whose first full-time job doesn't pay much. If these individuals have investment earnings, they can sell them and not have to worry about offsetting gains by selling assets that will produce a loss.
Wash away those losers?
But what if the only deflated stocks in your portfolio have a lot of promise to rebound to profitable glory? You might think of selling something off to create a loss, and then repurchasing the stock so you can ride it back up.
Not so fast, bucko. The IRS is a step ahead. The tax folks closed up that loophole with something called the wash sale rule. The catch is you can't claim a loss from the sale of a security and then turn around and buy a substantially identical replacement within 30 days.
For example, if you sell a stock and then pick it up again a week later after it splits, the IRS knows it's still the same stock. So if you want the tax break, you have to take a risk and wait 31 days to pick up that stock or security again.
For a more subtle way to work within the wash sale rule, you could sell shares of one company's mutual fund and pick up the same type of fund from another company. For example, sell off the Fidelity's Health Care mutual fund and then buy into the Vanguard Health Care mutual fund. For bonds, be sure to buy a new one that differs from the old one in one or, even better, two of the following criteria: issuer, credit rating, maturity and yield.
Though capital losses can lessen the pain from a gain, they are not the way to wealth. Your ideal financial scenario would be for every stock to be a long-term winner. But for that you need a crystal ball, not a tax form.