Understanding the rules surrounding investment losses can really help minimize your tax obligation each year. This is because investment gains and income can be subject to a variety of federal tax rates as high as 39.6%. This and a newly minted tax law in 2013 that could add a 3.8% Medicare investment tax surcharge make planning around when to take investment losses an important tax planning subject.
Know the meaningful rules
What makes investment losses such an important tax planning subject? Here are the relevant tax ramifications surrounding investment losses.
- Offsetting gains. Investment losses can be used to offset investment gains every year.
- Short-term versus long-term. Short-term investment gains (from assets owned by you for less than one year) can be subject to ordinary income tax rates up to 39.6% while long-term gains have a maximum tax rate of 20% (0% if your income is in the 15% income tax bracket or lower).
- Netting rules. You first net investment losses against investment gains prior to applying losses against your ordinary income. Where possible you must net short-term losses against short-term gains and long-term losses against long-term gains.
- Excess losses. Up to $3,000 of excess investment losses can be used to offset your ordinary income in any one year.
- Unused losses. Unused losses can be carried forward to offset income in future tax years.
So given these rules, here are some tips.
Maximizing the impact of investment losses
- Net losses against short-term gains whenever possible. If you are in a high income tax bracket, try to sell stocks with a loss to offset any investments you wish to sell that you have owned less than one year.
- Defer taking losses if they will be used to offset lower taxed gains.
- Time taking an investment loss to take advantage of the annual $3,000 reduction of income it provides.
- Transfer stock from a low tax rate family member to a higher taxed individual.
- Take full advantage of the loss carry-forward rules. If you sold an investment that had a huge loss in a prior year, you can only take $3,000 against your regular income each year. If this applies to you, conduct an annual review of your portfolio and consider selling investments with a gain to offset more of this loss carry-forward.
Remember, investment losses can be used to offset investment gains and a limited amount of your ordinary income. Since the tax rates vary so greatly, proper planning to match losses against higher taxed items can make these losers a real winner on your tax return.