Factoring taxes into your investment planning

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, such as type of investment, type of income it produces, how long you’ve held it and whether any special limitations or breaks apply. And 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. The Tax Cuts and Jobs Act (TCJA) didn't repeal the NIIT or change the long-term capital gain rates, but its changes to ordinary income tax rates and tax brackets are having an impact on the tax paid on investments.

Yet, it’s unwise to make investment decisions based solely on tax consequences — you should consider your investment goals, time horizon, risk tolerance, factors related to the investment itself, fees and charges that apply to buying and selling securities, and your need for cash 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. Your marginal long-term capital gains rate can be as much as 20 percentage points lower than your ordinary-income rate.

The long-term gains rate applies to investments held for more than 12 months. The rate varies depending on your income and the type of assets.

Through 2025, the top long-term gains rate of 20% kicks in before the top ordinary-income rate does. Lawmakers could, however, make changes to the rates sooner. Higher rates already apply to certain types of assets.

Holding on to an investment until you’ve owned it more than one year may help substantially cut tax on any gain. Keeping it even longer can also make tax sense. But be sure to look at your specific situation, and keep an eye out for possible tax law changes.

The 0% rate

The 0% rate generally applies to long-term gain that would be taxed at 10% or 12% 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.

But keep in mind that the 0% rate applies only to the extent that capital gains “fill up” the gap between your child’s taxable income and the top end of the 0% bracket.

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.

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).

Also beware that the NIIT kicks in at significantly lower levels of income than the top ordinary-income and long-term capital gains rates. 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.

Being tax-smart with losses

Losses aren’t truly losses until they’re realized — that is, generally until you sell the investment for less than what you paid for it. So while it’s distressing to see an account statement that shows a large loss, the loss won’t affect your current tax situation as long as you still own the investment.

Realized capital losses are netted against realized capital gains to determine capital gains tax liability. If net losses exceed net gains, you can deduct only $3,000 ($1,500 for married taxpayers filing separately) of losses per year against ordinary income (such as wages, self-employment and business income, interest, dividends, and taxable retirement plan distributions). If year-to-date you have a net loss, it could provide an opportunity to tax efficiently divest yourself of appreciated investments.

If you don’t have enough gains to absorb losses, you could be left with losses in excess of the annual ordinary-income deduction limit. So think twice before selling an investment at a loss. After all, if you hold on to the investment, it may recover the lost value. In fact, a buy-and-hold strategy works well for many long-term investors because it can minimize the effects of market volatility.

Of course, an investment might continue to lose value. That’s one reason why tax considerations shouldn’t be the primary driver of investment decisions. Plus, you can carry forward excess losses until death, and building up losses for future use could be beneficial.

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

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:

  • Sell the security and 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,
  • Sell the security and 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.

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. For mutual funds you acquired after 2011, brokerage firms are required to track (and report to the IRS) your cost basis.

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 100% of their gain if they’ve held the stock for more than five years. But, depending on the acquisition date, the exclusion may be less: The exclusion is 75% for stock acquired on or after Feb. 18, 2009, and before Sept. 28, 2010; it’s 50% for stock acquired before Feb. 18, 2009.

When the exclusion is less than 100%, 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. 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 and where income or loss flows through to your tax return, 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 each tax year.

To avoid passive activity treatment, you must “materially participate” in the activity, which typically means 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. But there are other ways to meet the material participation test. Plus, special rules apply to real estate; see “Real estate activity rules."

To help ensure your hours claim will be able to withstand IRS scrutiny, carefully track and document your time. Contemporaneous recordkeeping is better than records that are created after-the-fact. 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.

Warning: Even if you do pass the material participation test, be aware that your loss deduction might still be limited under the TCJA’s business loss deduction rules.

Income investments

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

Interest income is generally taxed at ordinary-income rates, which can be as high as 37%. So stocks that pay qualified dividends currently may be more attractive tax-wise than other income investments, such as CDs and taxable bonds.

Some dividends are already 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: Tax-exempt interest from private-activity municipal bonds can trigger or increase AMT liability. However, any income from tax-exempt bonds issued in 2009 and 2010 (along with 2009 and 2010 re-fundings of bonds issued after Dec. 31, 2003, and before Jan. 1, 2009) is excluded from the AMT. And AMT is less of a risk for most taxpayers now.

Investment interest expense

Investment interest expense — interest on debt used to buy assets held for investment, such as margin debt used to buy securities — is still deductible for both regular tax and AMT purposes. However, it's an itemized deduction and, because of the higher standard deduction through 2025, taking the standard deduction may now be better for some taxpayers who have typically itemized in the past.

Also, the investment interest expense deduction is subject to some rules that may make it less attractive. It's 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 expense is carried forward, and you can deduct it in a later year against 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 expense. 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.