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Now that Thanksgiving weekend is coming to a close, I’m sure all of you are thinking about the same thing I am – taxes! OK, maybe it’s just me, but you should be thinking about taxes too, because this is the time when you can save yourself thousands of dollars in taxes if you invest in individual stocks.
You see, because you report capital gains by the year, it is the net total of your gains and losses that determines what your tax bill will be in April. If you sold a long-term gainer that went up 20,000% during the fifteen years you held it, most of that money will be taxed at your capital gains rate. It is wise to check with an accountant to determine what your tax burden will be since the rules are complicated and change often, but in general it is best to minimize the gains you make to reduce your taxes. If your income is low enough, you can even avoid capital gains entirely.
You can also reduce your taxes by offsetting a gain with a loss. It works like this:
Let’s say that you have 1000 shares of XYZ stock and have a gain of $20,000. You need some money to send your child to school, so you sell the shares, making a capital gain. You also have 1000 shares of ZZX that you bought at $40 that are now sitting at $25 per share. You’ve decided that there are better places to invest your money, so you want to sell. If you sell before January 1st, you could use the $15,000 loss on ZZX to offset the $20,000 gain on XYZ, so you’d only pay capital gains taxes on the difference because your net gain for the year would be $5,000. If you sell ZZX after the new year, you would need to pay taxes on the full $20,000 gain on XYZ. You could offset gains made the next year using the loss from ZZX, but not this year.
You need to be cautious, however, to avoid something called a “wash sale.” Let’s say that you still like ZZX but wanted to take the loss to offset your gain. You decide to sell the 1000 shares, then turn right around and buy 1000 more shares of ZZY. You figure that you could then record a $15,000 loss but still have 1000 shares of ZZY.
If you do use mutual funds and are looking for ways to choose types of funds, check out my new mini-book, Sample Mutual Fund Portfolios. It goes through fund allocations for different types of accounts, from 401ks and IRAs to college accounts, saving up for things and accounts for spending during your retirement years or other times where you’re using money from a portfolio to fund your lifestyle.
Now really, you have taken a loss. You are $15,000 poorer than you were when you purchased the 1000 shares of ZZX originally even though you still own 1000 shares of the stock. The IRS does not see it this way, however. Because you immediately took a position in the stock that was substantially the same, or in this case, exactly the same, they call it a wash sale. As a result, you would not be able to deduct the loss. This is not a criminal action – you wouldn’t be assessed penalties for the wash sale unless you report it wrong on your taxes – but you don’t get to report the loss, which is like a penalty on its own.
Well, maybe you decide to be smart and buy 1000 more shares of ZZX first, then sell the shares. Unfortunately, the IRS is wise to you here as well. It would still be a wash sale even if you bought the shares first. So how do you avoid this issue?
Well, one way is to wait 30 days, either after you sell the shares before you buy more, or after you buy more shares before you sell the original ones. If you sell them first, you take a chance that the stock may shoot up while you’re waiting. Given that it is the end of the year and stocks tend to do well as people pour money into their retirement accounts, this is a real possibility. You could also buy more shares, wait 30 days, then sell the original shares. The only issue with this strategy is that you now have a very big position in the stock, which could go badly should the price of the shares continue to fall. You’re also nearly too late to use this tactic this year, given that we barely have 30 days left, but this is something to consider for next year. (A word of caution: I would check the tax rules very carefully, and maybe consult an accountant if you plan to buy on the 1st and sell on the 31st since you’re cutting it really close, plus make sure you’ll be able to make the sale on the 31st with everything else going on.)
Note there are no wash sale rules if you sell a stock at a profit. The IRS is happy to have you take gains and pay the taxes, so you could take a gain and immediately get back into the same stock if you wish. This might be some thing to consider if you have already taken a loss on a stock and have a few winners. You could move your cost basis up this way and reduce your taxes in the future.
Again, with anything having to do with taxes, I highly suggest you talk to an accountant since the rules can change and there may be something special about your situation that may change the rule for you. I am not an accountant and don’t pretend to be.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
