Many federal employees and annuitants have brokerage accounts in which they have purchased capital assets for investment purposes. These capital asset investments include stocks, bonds, exchange-traded funds (ETFs), “open-ended” (mutual) funds, and “closed -end” Funds. Frequently, capital asset investments can lose value over time.
While a capital asset investment’s lost value can be discouraging to the investment owner, some good may come out in the form of tax savings. The tax strategy that changes a capital asset investment that has lost value into a tax “winner” is called tax-loss “harvesting” which is discussed in this column.
The column explains how tax-loss “harvesting” works and how it can help manage an individual’s taxes. Tax-loss “harvesting” can be particularly useful during December when individuals are looking for ways to save on current year income taxes. Tax-loss “harvesting” is used for capital asset investments held in non-retirement accounts (cannot be used in retirement accounts such as the TSP, 401(k) plans, and IRAs).
When a capital asset investment such as a stock, bond, ETF, mutual fund, or a closed-end fund is purchased by an investor, the investor pays a certain amount for the capital asset plus any commission, mark-up, etc. resulting in the investor’s having a certain “adjusted cost basis” in the capital asset.
Subsequent to purchasing the capital asset investment, the investor may sell the investment. If the net sales proceeds (sales price less any sales charges such as commissions) exceed the adjusted cost basis of the investment, the investor incurs an investment (capital) gain (referred to from now on as capital gain). If the net sales proceeds are less than the adjusted cost basis of the investment, then the investor incurs an investment (capital) loss (referred to from now as a capital loss).
A capital loss can be utilized to accomplish two different things, both of which result in tax savings. A capital loss: (1) Can be used to offset a capital gain – “dollar for dollar”; or (2) can offset up to $3,000 of ordinary income (wages, interest, pension) and other income per year.
Unused capital losses can be carried forward from one tax year to the next tax year indefinitely resulting in future tax savings for an investor. The idea of tax-loss “harvesting” in order to generate capital losses and the associated tax savings sounds like a great strategy. But there are important details that investors must know about tax-loss “harvesting” before engaging in it, which are now discussed.
Short-term versus long-term capital gains and losses
There are two types of capital gains and capital losses, namely, “short-term” and “long-term”.
“Short-term” capital gains and losses are those realized from the sale of capital assets that have been owned for one year or less. “Long-term” capital gains and losses that are realized after selling capital assets owned longer than one year.
The most important difference between short and long-term capital gains is the tax rate that they are taxed. Short-term capital gains are taxed at an investor’s marginal tax bracket as ordinary income is taxed. Ordinary income includes wages/salaries, net self- employment income, interest income, retirement income and rental income. The top marginal federal marginal tax rate on ordinary income is 37 percent.
For those individuals who are subject to the net investment income tax (NITT) of 3.8 percent, the effective tax rate can be as much as 40.8 percent. With state and local taxes added, an investor could pay as much as 50 percent in total taxes upon the sale of a capital asset, resulting in a short-term capital gain.
But for long-term capital gain income, federal “preferential” capital gains tax rates apply, as presented in the following table:
Long-Term Capital Gain Tax Rates for 2020
Note that when the 3.8 percent NITT applies, the actual long-term capital-gains tax rate for high income individuals can be as much as 23.8 percent.
“Open-ended” fund (mutual fund) gains and losses
Those individuals who invest in mutual funds typically receive short-term capital and long-term capital gains in the form of mutual fund distributions. Mutual fund investors should keep a close eye on the funds projected distribution dates for capital gains. The current month of December is a popular month for mutual funds to make their fund distributions. Harvested losses can be used to offset these gains.
However, short-term capital gains distributions from mutual funds are treated as “nonqualified” dividend income and taxed at ordinary tax rates, not capital gain preferential rates. Unlike short-term capital gains (resulting from the sale of capital asset investments held directly, an investor cannot offset short-term capital gains distributions from a mutual fund.
How to “harvest” losses to maximize tax savings
It is important than when individuals are looking for tax-loss selling capital asset investment candidates, that the following investments should be considered:
(1) Those investments that no longer fit an investor’s investment strategy;
(2) those investments that have poor prospects for future growth; or
(3) those investments that can be easily replaced by other investments that fill a similar role.
Individuals looking to save on 2020 income taxes using tax-loss harvesting are advised to focus on short-term capital losses. This is because a short-term capital loss provides the greatest tax benefit as a result of being first used to offset short-term capital gains – and short-term capital gains are taxed at the individual’s higher marginal tax rate.
In accordance with the Internal Revenue Code (IRC), short- and long-term capital losses must be first used to offset capital gains of the same type. But if an individual’s capital losses of one type exceed the capital gains of the same type, then the individual can apply the excess capital losses to the other type. The following example illustrates.
Example: Julie sells a long-term held capital asset investment at a $25,000 capital loss but only had $10,000 in long-term capital gains for the year. Julie can apply the remaining $15,000 excess capital loss to any short-term capital gains.
If an individual has harvested short-term capital losses but has unrealized long-term capital gains, then the individual may want to consider realizing the capital gains in the future (that is, actually selling and incurring those gains in order for the unrealized gains to be “recognized” gains). The least effective tax-oriented use of harvested short-term capital losses would be to apply them to long-term capital gains. However, for some individuals, that may be preferable to paying the long-term capital gains tax.
In addition, a realized capital loss can be effective even if an individual did not realize capital gains in a particular year. This is because the tax code allows individuals to apply up to $3,000 a year in capital losses to reduce other income (salaries, interest, pensions, rental income) which is taxed at the same marginal tax rate as short-term capital gains. In addition, any unused capital losses can be carried forward for use in future years.
Finally, in utilizing “harvesting” tax losses in order to maximize tax savings, it is important for individual investors not to undermine their overall financial goals, including staying diversified in their capital asset investment portfolios. Individuals should also be aware of the IRS’ “wash sales” rules which, if violated, could result in disallowed capital losses. Additional questions about the tax loss “harvesting” as well as the IRS’ “wash sale” rules should be directed to a qualified tax professional.