Reducing Taxes When You Take Profits
Look at All Your Gains The first step toward tax efficiency is to review your portfolio. Get a sense of your current tax profile. First look at your realized gain, which is gain from an investment that you have already sold for a profit. Then look at your unrealized gains. If your portfolio has appreciated, you may have unrealized gains in investments that have not yet been sold.
Remember that gains may be found in many different types of investments. When determining your overall portfolio gains, consider the following items:
- Stock positions
- Corporate bonds
- Treasury and Agency instruments
- Tax-exempt municipal bonds and bond funds
- Unit investment trusts
- Mutual fund shares
- Long-term capital gain distributions from mutual funds
- Long-term capital gain distributions from tax-exempt bond funds
- Equity options (closing transactions or upon expiration)
- Index options
When you are selling a security and will realize a capital gain, consider planning when to take the gains. If a security has appreciated, consider waiting until the holding period for long-term capital gains (more than one year) has passed. For securities that will shortly become long term, the taxes saved could be significant. If, however, you are selling stock at a loss, consult with your tax advisor to determine which holding period is most tax-efficient.
Types of Gains and Losses
Capital gains and losses may be short term or long term, depending on how long you held the security before sale. Short-term capital gains or losses are from the sale of a security held for twelve months or less. Net short-term gains are taxed at ordinary income tax rates. On the other hand, long-term capital gains or losses are from the sale of a security held for more than twelve months (at least twelve months and one day). Net long-term capital gains are taxed at a 15% tax rate (0% for those in the 15% or lower tax brackets for 2009 through 2012).
Choosing Multiple Stock Lots
Identifying which lot of a security to sell is an important part of tax efficiency. When various lots of the same security are bought and sold at different times and at different prices, the ability to identify the specific security sold creates a tax-planning opportunity.
By specifically identifying the lot to be sold at the time of the sale, you can essentially control the amount of capital gain to be recognized and whether the gain will be short term or long term.
Reducing Your Capital Gains by Maximizing Your Losses
In addition to reducing your taxable gains, one of the keys to tax-efficient portfolio management is maximizing use of your losses. If you sell an appreciated security and realize a capital gain, you may be able to reduce or eliminate the capital gain by also selling a security that has gone down in value for a capital loss. If the gain you realize is completely offset by a loss, you have effectively created a current tax-free source of income. Offset of Gains and Losses
Capital gains and losses offset each other in a manner based on whether the gains and losses are short term or long term. After you have offset capital gains and losses in the prescribed order, any remaining losses can be used to offset up to $3,000 of ordinary income. Capital losses in excess of this dollar amount may be carried over to succeeding tax years until used.
Look at Your Entire Portfolio
Take a look at all of your investments. Losses may be present in many different types of investments. You can use a capital loss from one type of investment to offset a capital gain from another type of investment.
Choosing Multiple Stock Lots
Specific identification does not apply only to gains. When you are selling for a capital loss and have multiple stock lots, be sure to identify the lot you want sold. By specifically identifying the lot to be sold at the time of the sale and no later, you can ensure that the lot with a loss has been sold. In addition, you can essentially control the amount of the loss to be recognized and whether the loss is short term or long term.
Tax Swapping-Turning a Loss into a Benefit
Some investors only consider tax swapping when they already have a realized gain from the sale of a security. However, tax swapping is also an effective way to upgrade your portfolio and thus increase your after-tax performance. If you own a depressed investment, a swap may allow you to generate a tax loss and purchase another investment that will upgrade your portfolio. Losses realized from a tax swap may be used to offset other realized gains from the sale of securities and potentially increase the after-tax return of your portfolio. However, if the newly purchased security is "substantially identical" to the security sold, then the wash sale rules (discussed later) may disallow the loss for the current year. Bond Swaps
You may own a bond that is currently selling below its cost basis due to a shift in the interest rates or a change in the credit quality of the issuer. With a bond swap, you can tax swap within the same type of bond-for example, sell a municipal bond and purchase a different municipal bond. Or you can swap different types of bonds-for example, sell a government bond and purchase a corporate bond.
Stock Swaps
You may swap out of stock that has decreased in value and swap into another stock in the same or different industry.
Don't Overlook the Wash Sale Rule
If you sell and buy back the identical investment solely to generate a tax loss, the loss will be disallowed for the current tax year if you purchase a substantially identical security or option to buy that security within 30 days before or after the sale. The effect of the wash sale rule is to defer the benefit of your tax loss until you sell the newly purchased security. The IRS has indicated that if you sell a security at a loss in your personal account and then buy the same or substantially identical securities within your IRA within this same period, that will also be considered a wash sale. However, since you don't get a tax benefit from losses within an IRA, you may lose any tax benefit from that economic loss.
Your Next Step
You should review your portfolio for performance and tax efficiency and determine which ideas may be best for your situation. Although Prudential Financial, its affiliates, and their financial professionals do not provide tax advice, your Prudential financial professional would be happy to work with you and your tax advisor to help you work toward your financial goals.