The early bird often gets the worm. So you might not wait until the waning days of the year to harvest capital losses from selling securities held in taxable brokerage firm accounts.
Strategy: Cash in your stock losers soon. You can use the losses to offset capital gains realized this year plus up to $3,000 of ordinary income.
The main impetus to take down capital losses earlier than usual is to ensure you’ll be able to minimize the impact of higher taxes in 2013.
Here’s the whole story: First, under the American Taxpayer Relief Act of 2012 (ATRA), the top federal income tax rate for ordinary income, including short-term capital gains (e.g., from sales of securities held a year or less), jumps from 35% to 39.6%, beginning in 2013. Second, ATRA increases the maximum tax rate on long-term capital gains from 15% to 20% for the same group of taxpayers. Third, a new 3.8% Medicare surtax may apply to investment income, including capital gains.
When you combine these three tax hikes, your effective tax rate on short-term capital gains could reach a staggering 43.4%! Plus you may owe state income tax, too. Long-term capital gains could be taxed at a rate as high as 23.4% (plus state income tax).
As a result, you don’t want to miss the boat when good selling opportunities present themselves. Assuming it makes overall investment sense, sell now and avoid the year-end crush.
Example: You recognized a $10,000 gain in May by selling a stock you’ve owned for six months. But you have another stock in your portfolio showing an $11,000 loss. According to your estimates, you expect to be in the top tax bracket and will have to pay the 3.8% surtax on any additional investment income you realize in 2013.
If you don’t sell off your “loser,” you’ll owe tax of $3,960 on your short-term $10,000 gain plus another $380 in Medicare surtax for a total of $4,340. However, if you sell the loser stock for $11,000, you’ll completely offset the earlier capital gain, so the tax bill is zero. Plus, you can use the excess $1,000 loss to offset other high-taxed income.
Tip: The idea is to harvest losses when they can provide the biggest tax bang. Then you can reassess your tax liability at the end of the year.