When it comes to tax planning and your investments, it can be difficult to know where to start. First, tax treatment of investments varies based on a number of factors, such as type of investment, type of income it produces, how long you’ve held it and whether any special limitations or breaks apply. And you need to understand the potential tax consequences of buying, holding and selling a particular investment. Higher-income taxpayers also need to know when higher capital gains tax rates and the NIIT kick in. The Tax Cuts and Jobs Act (TCJA) didn’t repeal the NIIT or change the long-term capital gain rates, but its changes to ordinary income tax rates and tax brackets are having an impact on the tax paid on investments.
Yet, it’s unwise to make investment decisions based solely on tax consequences — you should consider your investment goals, time horizon, risk tolerance, factors related to the investment itself, fees and charges that apply to buying and selling securities, and your need for cash as well.
Finally, your portfolio and your resulting tax picture can change quickly because of market volatility. Vigilance is necessary to achieve both your tax and investment goals.
Losses aren’t truly losses until they’re realized — that is, generally until you sell the investment for less than what you paid for it. So while it’s distressing to see an account statement that shows a large loss, the loss won’t affect your current tax situation as long as you still own the investment.
Realized capital losses are netted against realized capital gains to determine capital gains tax liability. If net losses exceed net gains, you can deduct only $3,000 ($1,500 for married taxpayers filing separately) of losses per year against ordinary income (such as wages, self-employment and business income, interest, dividends, and taxable retirement plan distributions). But you can carry forward excess losses until death. In the current market, you may not have enough gains to absorb losses, which could leave you with losses in excess of the annual ordinary-income deduction limit. So think twice before selling an investment at a loss. After all, if you hold on to the investment, it may recover the lost value. In fact, a buy-and-hold strategy works well for many long-term investors because it can minimize the effects of market volatility.
Of course, an investment might continue to lose value. That’s one reason why tax considerations shouldn’t be the primary driver of investment decisions. If you’re ready to divest yourself of a poorly performing stock because, for example, you don’t think its performance will improve or your investment objective or risk tolerance has changed, don’t hesitate solely for tax reasons.
Plus, building up losses for future use could be beneficial. This may be especially true if you have a large investment portfolio, real estate holdings or a closely held business that might generate substantial future gains.
Finally, remember that capital gains distributions from mutual funds can also absorb capital losses.