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Time to take another look at the impact of taxes on your portfolio

When it comes to investing, the focus is often on returns — without regard to their potential tax impact. Because tax rates have continued to be relatively low, it’s not surprising that there’s been more focus on stock market volatility than on tax consequences. But, while the Tax Cuts and Jobs Act (TCJA) didn’t change the long-term capital gains rates, its changes to ordinary-income tax rates and tax brackets do affect the tax you pay on investments. So it’s time to take another look at the impact of taxes on your portfolio.

Capital gains tax and timing

Although time, not timing, is generally the key to long-term investment success, timing can have a dramatic impact on the tax consequences of investment activities. Your long-term capital gains rate can be as much as 20 percentage points lower than your ordinary-income tax rate, even with the reductions to most
ordinary-income rates under the TCJA. The long-term gains rate applies to investments held for more than 12 months and remains at 15% for middle-bracket taxpayers. A 20% long-term capital gains rate still applies to higher-income taxpayers.

Because of TCJA-related changes to the brackets, through 2025, the 20% rate kicks in before the top ordinary-income rate does. Higher rates also still apply to certain types of assets. But taxpayers in the bottom two brackets generally continue to enjoy a 0% long-term capital gains rate.

Holding on to an investment until you’ve owned it more than one year may help substantially cut tax on any gain. Here are some other tax-saving strategies related to timing:

Use unrealized losses to absorb gains. To determine capital gains tax liability, realized capital gains are netted against realized capital losses. Both long- and short-term gains and losses can offset one another. If you’ve cashed in some big gains during the year and want to reduce your 2019 tax liability, look for unrealized losses in your portfolio and consider selling them before year-end to offset your gains.

Avoid wash sales. If you want to achieve a tax loss with minimal change in your portfolio’s asset allocation, consider the wash sale rule. It prevents you from taking a loss on a security if you buy a substantially identical security (or an option to buy such a security) within 30 days before or after you sell the security that
created the loss. You can recognize the loss only when you sell the replacement security.

Fortunately, there are ways to avoid triggering the wash sale rule and still achieve your goals. For example, you can immediately buy securities of a different company in the same industry or shares in a mutual fund that holds securities much like the ones you sold. Or, you can wait 31 days to repurchase the same security. Alternatively, before selling the security, you can purchase additional shares of that security equal to the number you want to sell at a loss, and
then wait 31 days to sell the original portion.

Swap your bonds. With a bond swap, you sell a bond, take a loss and then immediately buy another bond of similar quality and duration from a different issuer. Generally, the wash sale rule doesn’t apply because the bonds aren’t considered substantially identical. Thus, you achieve a tax loss with virtually no change
in economic positioning.

Mind your mutual funds. Mutual funds with high turnover rates can create income that’s taxed at ordinary-income rates. Choosing funds that provide primarily long-term gains can save you more tax dollars because of the lower long-term rates.

Also, pay attention to earnings reinvestments. Unless you or your investment advisor increases your basis accordingly, you may report more gain than required when you sell the fund. Brokerage firms are required to track (and report to the IRS) your cost basis in mutual funds acquired during the tax year.

Finally, beware of buying equity mutual fund shares late in the year. Such funds often declare a large capital gains distribution at year-end. If you own the shares on the distribution’s record date, you’ll be taxed on the full distribution amount even if it includes significant gains realized by the fund before you owned the shares.

Loss carryovers

If net losses exceed net gains, you can deduct only $3,000 ($1,500 for married taxpayers filing separately) of the net losses per year against other income (such as wages, self-employment and business income, dividends and interest).

You can carry forward excess losses until death. Loss carryovers can be a powerful tax-saving tool in future years if you have a large investment portfolio, real estate holdings or a closely held business that might generate substantial future capital gains.

Income investments

Some types of investments produce income in the form of dividends or interest. Here are some tax consequences to consider:

Dividend-producing investments. Qualified dividends are taxed at the favorable long-term capital gains tax rate rather than at your higher ordinary-income tax rate.

Interest-producing investments. Interest income generally is taxed at ordinary-income rates. So stocks that pay qualified dividends may be more attractive taxwise than other income investments, such as CDs and taxable bonds. But also consider nontax issues, such as investment risk, rate of return and diversification.

Bonds. These also produce interest income, but the tax treatment varies:

  • Interest on U.S. government bonds is taxable on federal returns but exempt by federal law on state and local returns.
  • Interest on state and local government bonds is excludable on federal returns. If the bonds were issued in your home state, interest also may be excludable on your state return.
  • Tax-exempt interest from certain private-activity municipal bonds can trigger or increase the alternative minimum tax (AMT), but the AMT now occurs more rarely.
  • Corporate bond interest is taxable for federal and state purposes.
  • Bonds (except U.S. savings bonds) with original issue discount build up “interest” as they rise toward maturity. You’re generally considered to earn a portion of that interest annually — even though the bonds don’t pay this interest annually — and you must pay tax on it.

3.8% NIIT

Taxpayers with modified adjusted gross income (MAGI) over $200,000 per year ($250,000 if married filing jointly and $125,000 if married filing separately) may owe the net investment income tax, in addition to other taxes already discussed here. The NIIT equals 3.8% of the lesser of your net investment income or the
amount by which your MAGI exceeds the applicable threshold. Net investment income can include capital gains, dividends, interest, rental income and other investment-related income (but not business income or self-rental income from an active trade or business).

Many of the strategies that can help you save or defer income tax on your investments can also help you avoid or defer NIIT liability. And because the threshold for the NIIT is based on MAGI, strategies that reduce your MAGI could also help you avoid or reduce NIIT liability.

Nontax considerations

Although tax considerations are important, don’t let them control your investment decisions. Also consider your investment goals, time horizon, risk tolerance, factors related to the investment itself, and fees and charges that apply to buying and selling securities.