No, that headline is not a misprint. Normally, investors look to “harvest” capital losses when the stock market has climbed, to offset any capital gains they’ve recently realized. But this tax year is far from normal, so you might do the opposite of the usual.
Strategy: Sell securities that will produce long-term gain. Even if you show a large net gain for the year, you’ll benefit from the maximum federal capital gain tax rate of only 15%. The maximum rate is scheduled to increase to 20% in 2013.
What’s more, other tax rate increases that are supposed to take effect next year could make 2012 the optimal year to pull down capital gains.
Here’s the whole story: For tax purposes, your gains and losses from dispositions of capital assets—such as stocks, bonds and other securities—are “netted” together at the end of the year. So your capital gains and losses can effectively cancel each other out. To the extent you have an excess capital loss, it may be used to offset up to $3,000 of ordinary income. Any remainder is carried over to the next year.
If you show a net long-term gain (i.e., on sales of property you’ve held longer than one year), you pay tax at a rate no higher than 15% in 2012 (0% for certain lower-income investors). This is attributable to tax cuts passed during the Bush administration and extended, with modifications, last year. But the Bush tax cuts will end this year unless Congress enacts new legislation.
Also, tax rates are set to rise across-the-board in 2013, absent any changes. Significantly, the two top rates of 33% and 35% will jump to 36% and 39.6%, respectively. To add insult to injury, some high-income investors will have to pay an additional 3.8% Medicare surtax on a portion of their investment income, due to a provision in the 2010 health care law.
When the dust settles, you could end up paying tax on short-term capital gains and other ordinary income at a sky-high rate of 43.4% in 2013!
Due to the uncertain political climate in Washington this year, it’s anybody’s guess if these tax increases will remain on the books. But you can’t expect a lifeline either. The best approach is to plan for the worst and hope for the best. And that means starting to harvest capital gains when opportunities present themselves.
Simplified example: Let’s say you own a stock you purchased for $50,000 10 years ago that is now worth $75,000. If you sell the stock for $75,000 in 2012 and realize no other capital gain or loss transactions during the year, you’ll pay $3,750 in federal income tax (15% of your $25,000 gain). On the other hand, if you wait until next year and sell the stock at the same $75,000 price, you might owe $5,000 (20% of your $25,000 gain)—or $1,250 more.
Of course, every situation is different, plus you must factor in other economic considerations besides taxes. But the overall strategy, at least for the time being, is to try to maximize the favorable tax rate for long-term capital gains.
Tip: If the 2012 tax breaks are subsequently extended, you can still harvest tax losses at year-end.
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