No easy task: Tax planning for investments involves many considerations

When it comes to tax planning and your investments, it can be difficult to know where to start. First, tax treatment of investments varies based on a number of factors. You need to understand the potential tax consequences of buying, holding and selling a particular investment. Higher-income taxpayers also need to know when higher capital gains tax rates and the NIIT kick in. It's also important to keep in mind that the tax consequences of investment decisions could change, depending on what happens with tax reform legislation.

Yet, it’s unwise to make investment decisions based solely on tax consequences — you should consider your risk tolerance and desired return as well.

Finally, your portfolio and your resulting tax picture can change quickly because of market volatility. Vigilance is necessary to achieve both your tax and investment goals.

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. A taxpayer’s long-term capital gains rate can be as much as 20 percentage point lower than his or her ordinary-income tax rate. The long-term gains rate generally is 15% and applies to investments held for more than 12 months. (Higher long-term gains rates apply to higher-income taxpayers and to certain types of assets — see the Chart “What’s the maximum capital gains tax rate?”)

Holding on to an investment until you’ve owned it more than a year may help substantially cut tax on any gain — even if higher long-term gains rates apply. Also, remember that appreciating investments that don’t generate current income aren’t taxed until sold, deferring tax and perhaps allowing you to time the sale to your tax advantage — such as in a year when you have capital losses to absorb the capital gain. (See the Case Study “Taking advantage of capital losses.”) To determine capital gains tax liability, realized capital gains are netted against any realized capital losses.

If you’ve already cashed in some big gains during the year and want to reduce your tax liability, before year end look for unrealized losses in your portfolio and consider selling them to offset your gains.

The net investment income tax (NIIT)

Taxpayers with modified adjusted gross income (MAGI) over $200,000 per year ($250,000 for married filing jointly and $125,000 for married filing separately) are subject to this extra 3.8% tax on the lesser of their net investment income or the amount by which their MAGI exceeds the applicable threshold. Net investment income can include capital gains, dividends, interest and other investment-related income (but not self-rental income from an active trade or business). The rules are somewhat complex, so consult your tax advisor for more information.

Many of the strategies that can help save or defer income tax on investments can also help avoid or defer NIIT liability, such as using unrealized losses to absorb gains. And because the threshold for the NIIT is based on MAGI, strategies that reduce MAGI — such as making retirement plan contributions — could also help avoid or reduce NIIT liability.

It's also possible you won't have to worry about the NIIT at some point in the future. The tax is imposed under the Affordable Care Act (ACA), and it might be eliminated under ACA repeal and replace legislation or tax reform legislation.

The wash sale rule

If want to achieve a tax loss with minimal change in your portfolio’s asset allocation, keep in mind the wash sale rule. It prevents you from taking a loss on a security if you buy a substantially identical security (or option to buy such a security) within 30 days before or after you sell the security that created the loss. You can then 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,
  • Wait 31 days to repurchase the same security, or
  • Before selling the security, 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.

Alternatively, you can do a bond swap, where 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 won’t apply because the bonds aren’t considered substantially identical. Thus, you achieve a tax loss with virtually no change in economic position.

Warning: You cannot avoid the wash sale rule by selling stock at a loss in a taxable account and purchasing the same stock within 30 days in a tax-advantaged retirement account.

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.

Finally, remember that capital gains distributions from mutual funds can also absorb capital losses.

Paying attention to details

If you don’t pay attention to the details, the tax consequences of a sale may be different from what you expect. For example, the trade date, not the settlement date, of publicly traded securities determines the year in which you recognize the gain or loss.

And if you bought the same security at different times and prices and want to sell high-tax-basis shares to reduce gain or increase a loss and offset other gains, be sure to specifically identify which block of shares is being sold.

The 0% rate

The 0% rate applies to long-term gain that would be taxed at 10% or 15% based on the taxpayer’s ordinary-income rate. If you have adult children in one of these tax brackets, consider transferring appreciated or dividend-producing assets to them so they can sell the assets and enjoy the 0% rate, which also applies to qualified dividends. This strategy can be even more powerful if you’d be subject to the 3.8% NIIT or the 20% long-term capital gains rate if you sold the assets. (See the Case Study “How to qualify for the 0% capital gains rate.”)

Warning: If the child will be under age 24 on December 31, first make sure he or she won’t be subject to the “kiddie” tax. Also consider any gift tax consequences.

Mutual funds

Investing in mutual funds is an easy way to diversify your portfolio. But beware of the tax pitfalls. First, mutual funds with high turnover rates can create income 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.

Second, earnings on mutual funds are typically reinvested, and unless you (or your investment advisor) keep track of these additions — and increase 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.

Third, buying equity mutual fund shares later in the year can be costly tax-wise. Such funds often declare a large capital gains distribution at year end, which is a taxable event. 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. And you’ll pay tax on those gains in the current year — even if you reinvest the distribution. (See the Case Study “Watch out for mutual fund capital gains distributions.”)

Small business stock

By purchasing stock in certain small businesses, you can diversify your portfolio. You also may enjoy preferential tax treatment:

Conversion of capital loss to ordinary loss. If you sell qualifying Section 1244 small business stock at a loss, you can treat up to $50,000 ($100,000, if married filing jointly) as an ordinary, rather than a capital, loss — regardless of your holding period. This means you can use it to offset ordinary income, reducing your tax by as much as 35% of this portion of the loss. Sec. 1244 applies only if total capital invested isn’t more than $1 million.

Tax-free gain rollovers. If within 60 days of selling qualified small business (QSB) stock you buy other QSB stock with the proceeds, you can defer the tax on your gain until you dispose of the new stock. The rolled-over gain reduces your basis in the new stock. For determining long-term capital gains treatment, the new stock’s holding period includes the holding period of the stock you sold.

To be a QSB, a business must be engaged in an active trade or business and must not have assets that exceed $50 million, among other requirements.

Exclusion of gain. Generally, taxpayers selling QSB stock are allowed to exclude up to 50% of their gain as long as they’ve held the stock for at least five years. But, depending on the acquisition date, the exclusion may be greater: The exclusion is 75% for stock acquired after February 17, 2009, and before September 28, 2010, and 100% for stock acquired on or after September 28, 2010.

The taxable portion of any QSB gain will be subject to the lesser of your ordinary-income rate or 28%, rather than the normal long-term gains rate. (See the Chart “What’s the maximum capital gains tax rate?”) Thus, if the 28% rate and the 50% exclusion apply, the effective rate on the QSB gain will be 14% (28% × 50%).

Keep in mind that all three of these tax benefits are subject to specific requirements and limits. Consult your tax and financial advisors to be sure an investment in small business stock is right for you.

Passive activities

If you’ve invested in a trade or business in which you don’t materially participate, remember the passive activity rules. Why? Passive activity income may be subject to the NIIT, and passive activity losses generally are deductible only against income from other passive activities. You can carry forward disallowed losses to the following year, subject to the same limits.

To avoid passive activity treatment, typically you must participate in a trade or business more than 500 hours during the year or demonstrate that your involvement constitutes substantially all of the participation in the activity. (Special rules apply to real estate; see “Real estate activity losses.”) If you don’t pass this test, consider:

Increasing your involvement. If you can exceed 500 hours, the activity no longer will be subject to passive activity rules.

Grouping activities. You may be able to group certain activities together to be treated as one activity for tax purposes and exceed the 500-hour threshold. But the rules are complex, and there are potential downsides to consider.

Looking at other activities. Another option if you have passive losses is to limit your participation in another activity that’s generating income, so that you don’t meet the 500 hours test, or invest in another income-producing trade or business that will be passive to you. Under both strategies, you’ll have passive income that can absorb some or all of your passive losses.

Disposing of the activity. This generally allows you to deduct all the losses — including any loss on disposition (subject to basis and capital loss limitations). But, again, the rules are complex.

Income investments

Qualified dividends are taxed at the favorable long-term capital gains tax rather than your higher ordinary-income tax rate. (See the Chart “What’s the maximum capital gains tax rate?”)

Interest income is generally taxed at ordinary-income rates, which are now as high as 39.6%. So stocks that pay qualified dividends currently may be more attractive tax-wise than other income investments, such as CDs and taxable bonds. But there are exceptions.

Some dividends are subject to ordinary-income rates. These may include certain dividends from:

  • Real estate investment trusts (REITs),
  • Regulated investment companies (RICs),
  • Money market mutual funds, and
  • Certain foreign investments.

The tax treatment of bond income varies. For example:

  • Interest on U.S. government bonds is taxable on federal returns but exempt by law on state and local returns.
  • Interest on state and local government bonds is excludible on federal returns. If the bonds were issued in your home state, interest also may be excludible on your state return.
  • Corporate bond interest is fully taxable for federal and state purposes.
  • Bonds (except U.S. savings bonds) with original issue discount (OID) 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. (See the Case Study “The dangers of ‘phantom’ income.”)

Keep in mind that, although state and municipal bonds usually pay a lower interest rate, their rate of return may be higher than the after-tax rate of return for a taxable investment, depending on your tax rate. To compare apples to apples, calculate the tax-equivalent yield, which incorporates tax savings into the municipal bond’s yield. The formula is simple:

Tax-equivalent yield = actual yield / (1 - your marginal tax rate)

For an example of this formula in action, see the Case Study “Tax-exempt or taxable bonds? It's a question of yield.”

Warning: The NIIT also may apply to your dividend and interest income.

Investment interest expense

Investment interest — interest on debt used to buy assets held for investment, such as margin debt used to buy securities — is deductible for both regular tax and AMT purposes. But special rules apply.

Your investment interest deduction is limited to your net investment income, which generally includes taxable interest, nonqualified dividends and net short-term capital gains (but not long-term capital gains), reduced by other investment expenses. Any disallowed interest is carried forward, and you can deduct it in a later year if you have excess net investment income.

You may elect to treat net long-term capital gains or qualified dividends as investment income in order to deduct more of your investment interest. But if you do, that portion of the long-term capital gain or dividend is taxed at ordinary-income rates.

Payments a short seller makes to the stock lender in lieu of dividends may be deductible as an investment interest expense. But interest on debt used to buy securities that pay tax-exempt income, such as municipal bonds, isn’t deductible.

Also keep in mind that passive interest expense — interest on debt incurred to fund passive activity expenditures — becomes part of your overall passive activity income or loss, subject to limitations.