Taxes on equity investment gains may seem inevitable. But understanding the rules for investment-related taxes can give you the power to manage your tax liability more efficiently, even if you cannot avoid it. Heres an overview of some of the basic tax issues that an individual who buys and holds shares of stock in a taxable account might face.
Will income be taxed at ordinary or long-term capital gains tax rates?
This may be the most fundamental tax question you could face with regard to investment-related income. Ordinary income tax rates generally apply to certain money youve been paid, such as salaries, professional fees, and interest. But those rates also apply to the gains youve realized from the sale of a capital asset like stock that youve owned for one year or less.
The tax rate on long-term capital gains is much lower than the tax rate on ordinary income (a maximum rate of 23.8% on most capital gains, compared with a maximum ordinary income tax rate of 37% plus the 3.8% Net Investment Income Tax). Long-term capital gains are generally the gains youve realized from the sale of capital assets youve held for more than one year. So timing your stock sales so that any gains qualify as long-term capital gains might be a simple and important way to lower your tax bill.
A simple case of investment tax accounting
Assuming that you bought a single block of stock in a company on an established securities market on a particular day, held it in a taxable account, and owned no other shares of the same company in the same account, tax accounting could be relatively straightforward. Your initial cost for the investment (the formal term is cost basis) would be your purchase price plus the commissions and fees you paid to affect the purchase. Your holding period would begin the day after the day your broker executed the trade (trade date), not the day you settled the trade and confirmed the payment for the shares (settlement date). Then, if you decided to sell that entire block in one trade, your sale proceeds would be the price at which you agreed to sell the shares less any commissions and fees you paid to affect the sale. Your sale date used to determine your holding period generally would be the trade date of the sale (again, generally not the settlement date).
If you were to have sold the stock for more than your adjusted cost basis, youd have a taxable gain; if less, a loss. If you owned the stock for more than one year (generally measured from the day after the trade date of the purchase to the trade date of the sale), you would report that gain as a long-term capital gain. Otherwise, youd report any gain as a short-term capital gain for the year of the sale. If you were to have sold at a loss, you could use that capital loss to reduce any other capital gains you might have had. If the loss exceeded all of your capital gains for the year, you may be able to use any leftover amount (up to $3,000 per year) to reduce your ordinary income for the year. If there were any remaining capital losses after these steps, you could generally apply them to capital gains or income in future years, in what would be known as a capital loss carry forward.
Real life is usually not that simple
Many investors positions include shares that were acquired on different dates and at different prices, perhaps due to multiple trades, dividend reinvestment programs, or the exercise of options, warrants, and incentives.
Assuming that you have complete records that show how, when, and at what cost each portion of your position was acquired, you have two choices when you figure your taxes.
One option allows you to assume that you sold the shares youve held on to the longest and use that price information for your cost basis in figuring your gain or loss. This is called first in, first out (FIFO); it is the default assumption when your broker reports your stock sale to the IRS.
The other option is called specific identification, which means choosing which block of shares in your position you use to figure your cost basis. Specific identification may offer you the potential to manage the size of any gain or loss you might realize in a particular trade. However, to be eligible to use specific identification at tax time, you must have instructed your broker about which shares you were selling at the time of the trade (no later than settlement day). Your broker should provide written confirmation of the specific identification in writing within a reasonable period of time after the sale.
Here are some other significant considerations involving capital gains tax accounting for stock positions:
- If you do not have adequate records to assign specific prices to each portion of a stock position, the IRS requires you to use FIFO
- If you receive identical shares at no cost as a stock dividend, a split, or a similar corporate action, you must adjust the cost basis on the position that generated the new shares proportionately
- If you receive shares as part of an exchange, your cost basis normally includes the value of the securities you exchanged
- You cannot generally claim a loss at the time of the trade for tax purposes on a trade if you had purchased what the IRS calls substantially similar shares within 30 days before or after the trade that generated the loss. This is called a wash sale.
- When you purchase new shares as the result of exercising rights or options, you will need to account for the rights or options value as well as the shares value when determining gain or loss
What can you gain from choosing your cost basis?
If you want to trigger a relatively small tax bill, select the shares in the stock position that would produce the smallest possible capital gain when sold.
If you have a large capital gain elsewhere that youd like to offset, consider selling any shares that might generate a large capital loss. But remember that, even with an apparently losing position, the value of any immediate tax-loss harvesting should be balanced against the long-term potential of the company.
Finally, please keep in mind that this discussion is only a general guide. It may not address all of the factors relevant to your circumstances and needs. Seek professional tax advice before taking any action.
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The material was authored by a third party, DST Retirement Solutions, LLC, an SS&C company (SS&C), not affiliated with Merrill or any of its affiliates and is for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Merrill or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is in your best interest based on your particular circumstances and, if necessary, seek professional advice.
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