Five steps to help manage taxes on investment gains

Strategic tax-loss harvesting could help you reduce your taxes on realized capital gains for 2016.

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Sometimes an investment that has lost value can be a good thing—or at least, not all bad. You can sell stocks, bonds, mutual funds, or other investments that have lost value, to reduce taxes on realized capital gains from winning investments. It’s called tax-loss harvesting. 

Of course, losing money doesn’t feel good, but a well-diversified portfolio will usually contain some investments that have indeed lost value. But don't let taxes dictate your investing strategy. And because evaluating and managing the tax consequences of your investment decisions can be tricky, it’s always a good idea to consult a tax professional.

As the end of the year approaches, it’s a good time to review your 2016 tax situation. The key to an effective tax-loss harvesting strategy is to evaluate what you own and why you own it, identify investments that have lost value, and then consider the sale of some portion of those holdings to offset existing realized gains. And to do this while being careful not to stray from your target investment mix and diversification strategy. 

Here are five things to keep in mind as you see how tax-loss harvesting might help you lower your tax bill.

1. Assess your short-term and long-term capital gains for the year.

How you approach tax-loss harvesting depends on the type of investor you are. If you buy and sell frequently, you probably have short-term or long-term gains and losses for your trades. Short-term capital gains are those realized from investments that you have owned for one year or less. Long-term capital gains are realized on investments held longer than one year.

If you’re more of a buy-and-hold mutual fund investor, your gains may be in the form of mutual fund distributions. Keep a close eye on your funds’ projected distribution dates for capital gains.

You can check capital gains and losses in your nonretirement Fidelity accounts—and determine whether they’re short- term or long-term with our tax-loss harvesting tool (login required).

2. Estimate your capital-gains tax liability.

Once you roughly know the amount of your capital gains, you can estimate your potential tax liability from realized gains, based on your income and the type of gains.

Short-term capital gains are taxed at your marginal tax rate on ordinary income. The top marginal tax rate on ordinary income is 39.6%. For 2016, it applies to couples filing jointly with income above $466,950, and single taxpayers with income above $415,050. For those subject to the net investment income tax (NIIT), which is 3.8%, the effective rate can be as high as 43.4%. And with state and local income taxes added in, the rates can be even higher.

For long-term capital gains, the capital-gains tax rate applies, and it’s significantly lower. You won’t owe any long-term capital-gains tax if your 2016 taxable income is $75,300 or below and you are married filing jointly, or $37,650 or below if you are a single filer. For the majority of taxpayers—those with taxable income between $75,300 and $466,950 (married, joint filers) and $37,651 and $415,050 (single filers)—the long-term capital-gains rate is 15%.

High-income taxpayers, on the other hand, are subject to higher rates on capital gains. If your taxable income is more than $466,950 (married joint filers), or $415,050 (single filers), your marginal rate for long-term capital gains is at least 20%. When the 3.8% NIIT comes into play, the actual long-term capital-gains tax rate for high earners can be as much as 23.8%, and the actual rate applied to other investment income can be as high as 43.4%. The NIIT is levied on the lesser of net investment income or the amount by which modified adjusted gross income (MAGI) exceeds $250,000 for couples filing jointly, and $200,000 for single filers. For more information, read Viewpoints: “The Medicare tax and you.”

3. Harvest losses and prioritize your tax savings.

When you have a sense of how much you might owe in capital-gains tax, you can begin looking for tax-loss selling candidates. Consider investments that no longer fit your strategy, have poor prospects for future growth, or can be easily replaced by other investments that fill a similar role in your portfolio.

To enhance your potential tax savings, you should apply as much of your capital loss as possible to short-term gains, because they are taxed at a higher marginal rate. This is particularly true for high-income investors. For example, if you’re in the top tax bracket, the difference between short- and long-term gains can be as high as 19.6% (43.4% versus 23.8%). However, if you’re in the 25% tax bracket—$75,301 to $151,900 for joint filers and $37,651 to $91,150 for singles—the difference between the short- and long-term gains rate is 10% (25% versus 15%).

According to the tax code, short- and long-term losses must be used first to offset gains of the same type. But if your losses of one type exceed your gains of the same type, then you can apply the excess to the other type. For example, if you were to sell a long-term investment at a $15,000 loss but had only $5,000 in long-term gains for the year, you could apply the $10,000 excess to any short-term gains.

The least effective tax-loss harvesting strategy, on the other hand, would be to apply short-term capital losses to long-term capital gains. But, depending on the circumstances, that may still be preferable to paying the long-term capital gains tax.

Also, keep in mind that realizing a capital loss can be effective even if you didn’t realize capital gains this year. The tax code allows you to apply up to $3,000 a year in capital losses to reduce ordinary income, which is taxed at the same rate as short-term capital gains and nonqualified dividends. If you still have capital losses after applying them first to capital gains and then to ordinary income, you can carry them forward for use in future years until you use them all.

4. Stay diversified, but beware of wash sales.

After you have decided on depreciated investments to sell, you’ll have to determine what new investments, if any, to buy. Be careful, however, not to run afoul of the wash-sale rule.

Say you want to buy back the same security you sold, because you believe it has good prospects for future growth or because it would be difficult to find an investment that matches the diversification it provides for your portfolio. The wash-sale rule states that your tax write-off will be disallowed if you buy the same security, a contract or option to buy the security, or a “substantially identical” security, within 30 days before or after the date you sold the loss-generating investment.

One way to avoid a wash sale, while still investing in the industry of the stock you sold at a loss, would be to consider substituting an exchange-traded fund (ETF) that targets the same industry. Read Viewpoints: “Tax-loss harvesting using ETFs.”

Although some substitutions are clearly allowable, others may come closer to the IRS interpretation of what constitutes a “substantially identical” security. If you’re not sure, you should consult a tax advisor before making the purchase.

5. Make tax-loss harvesting part of your year-round tax and investing strategies.

The best way to maximize the value of tax-loss harvesting is to incorporate it into your year-round tax planning and investing strategy. Tax-loss harvesting and portfolio rebalancing are a natural fit. In addition to keeping your portfolio aligned with your goals, a once- or twice-a-year rebalancing provides an opportunity to reexamine lagging investments that could be candidates for tax-loss harvesting.

Also, take a look at how you are calculating the cost basis on your investments. Cost basis is simply the price you paid for a security, plus any brokerage costs or commissions. If you have acquired multiple lots of the same security over time, either through new purchases or dividend reinvestment, cost basis can be calculated either as a per-share average of all the purchases (the average-cost method) or by keeping track of the actual cost of each lot of shares (the actual-cost method). For tax-loss harvesting, the actual cost method has the advantage of enabling you to designate specific, higher-cost shares to sell, thus increasing the amount of the realized loss. Learn more about capital gains and cost basis.

Don’t undermine investment goals

If you choose to implement tax-loss harvesting, be sure to keep in mind that tax savings should not undermine your investing goals. Ultimately, a balanced strategy and frequent reevaluation to ensure that your investments are in line with your objectives are the smart approach.

Learn more

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Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.

1. The Fidelity® Personalized Portfolios service applies tax-sensitive investment management techniques (including tax-loss harvesting) on a limited basis, at its discretion, primarily with respect to determining when assets in a client’s account should be bought or sold. Because it is a discretionary investment management service, any assets contributed to an investor’s account that Fidelity® Personalized Portfolios does not elect to retain may be sold at any time after contribution. An investor may have a gain or loss when assets are sold.
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