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Opens the scrolled simulated dialogImportant Disclosures

Tax Planning for Investments

You have a capital gain when you sell an investment for more than you bought it for. Profit is a good thing, but capital gains are usually taxable. So it's important to consider the potential tax consequences before you make a transaction.

That said, taxes are likely just one factor in your decision. You may want to sell because the stock seems likely to lose value. You may need to rebalance the allocation of your portfolio. Or, you may want to reinvest the money elsewhere. In any of those cases, selling may be smart even if you'll have to share some of your profit with the IRS.

Remember that if you plan ahead, you may be able to offset your capital gains with capital losses. Capital losses occur when you sell an investment for less than you bought it for.

Figuring Gain or Loss

You calculate a gain by subtracting your cost basis from the sale price. Cost basis is what you paid for the item, plus the expense of buying, holding, and selling it. For example, if you paid $25 a share for 100 shares of a stock, plus a $6.95 commission, your cost basis at purchase would be $2,506.95. If you sold for $30 a share, plus a $6.95 commission, your capital gain would be $486.10 because you paid $6.95 to sell, too.

If you receive an asset as a gift, your basis is the same as the giver's was. If you inherit it, however, your basis is the market value on the date the giver's estate was valued.

If you hold an asset such as a stock for 12 months or more before you sell, you have a long-term gain. Most long-term gains are taxed based on your adjusted gross income (AGI), with the lowest rate set at 0%. Most investors pay 15%, while those with higher incomes pay 20%. Additional income-based surcharges also apply. If you hold an asset for less than 12 months, you have a short-term gain. These gains are taxed as ordinary income, at the same rate you pay on your regular income. So you may want to avoid them if possible.

You can subtract your long-term losses from your long-term gains and short-term losses from short-term gains to offset, or reduce, potential capital gains taxes. In fact, you may be able to erase all your gains and end up with a net loss.

Specific rules apply to figuring losses on investments you receive as gifts. You may want to consult your tax adviser to be sure you handle reporting them correctly.

Tax-saving maneuvers

There are a number of ways to reduce the tax you owe while building an investment portfolio.

  • You don't owe tax on the increasing value of an asset as long as you continue to own it. The market price of a stock you bought for $25 a share may climb to $40 a share, but no tax is due until you sell and realize the gain. So one strategy for reducing taxes involves investing part of your portfolio in assets with growth potential that you expect to hold for an extended period.
  • Since most dividends are taxed at your long-term capital gains rate, which is lower than the rate on your ordinary income, you might also consider buying dividend-paying stocks in your taxable accounts.
  • You may be able to take advantage of a variety of tax-deferred investments. Then no tax will be due on earnings in the account until you begin withdrawing, usually after you retire. Many employers sponsor tax-deferred retirement plans, such as 401(k)s, 403 (b)s, or 457s for their employees. Or you may open an individual retirement account (IRA). There are usually contribution limits on the amount you can invest each year in tax-deferred plans. But sometimes the amount you contribute is also tax deductible, saving you even more.
  • There are other alternatives, including Coverdell education savings accounts (ESAs), 529 college savings plans, Roth IRAs or Roth 401(k)s, 403(b)s or 457 plans. In these cases, you invest after-tax money but withdrawals are tax free, provided you follow the withdrawal rules that apply to the type of plan you have.

The gain of giving

If you donate assets that have increased in value, such as stock or a mutual fund, which you've held for over a year, you may be able to 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.