As a conscientious investor, you’re probably already keeping an eye on how your investments are performing this year. But you also should take the time to develop a strategy for minimizing taxes on those investments this year.
Holding investments long term
You can offset capital gains with capital losses. If your losses exceed your gains, you can offset the excess against up to $3,000 in ordinary income (with unused losses carried forward to future years).
Net short-term gains are taxed as ordinary income, while net long-term gains (gains on assets held more than 12 months) enjoy a rate as much as 20 percentage points lower. The long-term gains rate is 0% for taxpayers in the 10% or 15% ordinary-income bracket, 15% for taxpayers in the middle brackets and 20% for those in the 39.6% bracket (which for 2014 kicks in when taxable income exceeds $406,750 for singles, $432,200 for heads of households and $457,600 for joint filers).
Reducing NIIT liability
Your net gains (whether short- or long-term) might also be subject to the 3.8% net investment income tax (NIIT). Sometimes referred to as the “Medicare contribution tax,” the NIIT went into effect beginning in 2013 under the Affordable Care Act. It applies when modified adjusted gross income (MAGI) exceeds $200,000 for singles and heads of households and $250,000 for joint filers.
Because of the lower thresholds, you could owe the NIIT even if you’re not subject to the 20% long-term capital gains rate. The NIIT is applied to either your net investment income or your MAGI exceeding the applicable threshold, whichever is less.
Strategies that reduce your net capital gains will also reduce or perhaps even eliminate NIIT liability. You can also reduce or eliminate NIIT by implementing strategies to reduce MAGI, such as increasing contributions to traditional retirement plans.
Handling poor-performing investments
What if you still have high hopes for a poor-performing investment? One option is to sell the investment at a loss to generate tax benefits and then reinvest to keep your portfolio intact.
But you must beware of the wash sale rule. It prohibits a loss deduction if you acquire substantially the same security within 30 days before or after the sale. To avoid a wash sale, you can 1) sell the investment at a loss and wait 31 days to reinvest, or 2) buy replacement securities first and wait 31 days to sell the original investment. Either way, you assume the risk of price fluctuations during the 30-day waiting period.
Taking account of your nest egg
Can you use losses on stocks, bonds or mutual funds held in IRAs, 401(k) plans or other retirement accounts to generate tax benefits? Unfortunately, in most cases, the answer is no.
Traditional IRAs and employer-sponsored plans generally are funded with pretax dollars. Even if they’ve suffered substantial losses, if you sell the investments and close the account, the amount you withdraw will be treated as taxable ordinary income — and perhaps even subject to an early withdrawal penalty.
You may, however, be able to deduct losses in a traditional IRA if you’ve built up a sufficient tax basis through nondeductible contributions. Suppose, for example, that you’ve made $30,000 in nondeductible contributions to a traditional IRA but the IRA’s current value is only $20,000. If you close the IRA, you’ll realize a $10,000 loss.
Realizing a loss is one thing; realizing a tax benefit is another. First, you’ll also be required to close any other traditional IRAs you own (but not any Roth IRAs).
Second, the loss will be a miscellaneous itemized deduction. Such deductions are subject to a 2% of adjusted gross income (AGI) floor, so you’ll enjoy a tax benefit only if your total miscellaneous deductions exceed 2% of your AGI. Also watch out for the alternative minimum tax, which could eliminate an otherwise viable benefit.
Even if you’ve cleared all hurdles, you still might not want to withdraw the funds. Why? An IRA is a tax-sheltered investment. You may be better served in the long run by keeping the funds in the IRA. Or, converting from a traditional IRA to a Roth IRA might make sense. If the traditional IRA value is lower, the tax on a conversion will be lower.
Each person’s investment and tax strategies need to be tailored to his or her own financial situation. Contact us to discuss the tactics that will work best for you.