There’s Still Time to Act on these Year-End Tax Tips
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But are you also fully considering the big impact taxes can have on your trading or investing decisions? You should be.
First, keep in mind that you should never, ever allow potential tax to consequences dictate your trading or investing decisions. These must be based on your own investment strategy and discipline, your personal financial situation, and tolerance for volatility.
However, as part of your overall strategy, keeping the tax implications in the back of your mind can help improve your after-tax investment results. Specifically, helping you to keep more of the money you earn.
So, it’s important to spend some time thinking about this topic, especially now, just before year-end.
With this in mind, here are a few potential tax-saving tips you should think about over the next week. Because you may want to consider taking action before New Year’s Eve (when, by the way, the market will be open).
1: There’s BIG difference between capital gains tax ratesWhen it comes to how much tax you pay on your trading or investing profits, it all comes down to timing. Short-term trading strategies will often result in higher taxes.
But for investments you’ve held for more than one year, those transactions qualify for lower, long-term capital gains tax rates. And it makes a big difference.
Short-term gains (trades held less than one year) can be hit with the top federal tax rate of 40.8%. This breaks down as a 37% tax on short-term gains, plus a 3.8% Medicare surtax that’s tacked on top.
Long-term capital gains, meanwhile, qualify for a lower top federal tax rate of just 20%, or 23.8% total including the Medicare tax. You can see the significant difference between short- and long-term capital gains taxes illustrated in the table below from Fidelity Investments.
It blows my mind that short-term capital gains are taxed at almost double what you pay on long-term investment gains. But that’s our tax system at work, thanks to politicians in Washington who are constantly changing the tax code.
Now, as I said, you should not let your decisions be solely dictated by taxes. For instance, let’s say you have short-term gains in XYZ Inc., and the stock just triggered an exit signal within TradeSmith Finance.
You could continue to hold XYZ for more than a year, just to pay less in taxes. But you might wind up losing even more of your hard-earned money if XYZ shares keep falling.
In the end, you may be far better off just taking the larger tax hit and preserving your profits. It’s a tricky decision and you must carefully weigh the options, but following your investment discipline is always most important.
On the other hand, let’s say you’re holding ABC Corp. with big gains in less than a year. The stock is still in a healthy state as indicated by its Green Zone status. But you have your eye on another stock idea you think may offer even more upside potential.
So, your decision is whether to sell ABC or another position to raise cash for your new idea.
In this case, you may want to consider how much less in taxes you’ll pay by simply holding onto ABC shares for a bit longer. At least until after the one-year period that qualifies for lower long-term capital gains.
Meanwhile, consider grabbing your gains on another stock position you’ve already held for more than a year, and use that money to fund your new stock idea.
2: Always favor tax-advantaged accounts for short-term tradesMany investors use more than one brokerage account, and there can be big tax implications depending on the type of account used.
You may have an ordinary taxable brokerage account, perhaps a joint account with your spouse. And you may also have a tax-deferred IRA brokerage account. Be sure to use them wisely.
Consider using your taxable brokerage account — where you must pay taxes on your capital gains each year — to make your longer-term investments.
Meanwhile, consider using your IRA account to fund shorter-term trading strategies, including options trading.
Many folks don’t realize that you can trade a wide variety of stock or index options within an IRA. In fact, some brokers allow you to engage in futures trades within a retirement account if you wish.
When it comes to options, traders can use a wide variety of strategies within an IRA. This includes buying call and put options, selling covered calls, and more. Be sure to check with your broker for all the details.
3: ’Tis the season to consider tax-loss harvestingThis is a popular move to make at this time of year. In fact, tax-loss harvesting, or selling, often starts right after Thanksgiving and can continue until year-end. This technique is often practiced by professional fund managers and retail investors alike.
Tax-loss harvesting is simply the practice of selling losers in your portfolio to offset winning stocks that you may have sold earlier this year.
You could owe big short-term capital gains taxes on your biggest winners. So, you can simply offset those gains with losses you may be sitting on in other positions.
And this technique is especially useful in years like 2021 when stocks soared higher early in the year, then lost their upward momentum but are still ending with big gains for the year. Tax-loss harvesting may help significantly reduce your tax bill next April.
But be aware of the rules on wash sales.
The wash sale rule generally says that any tax losses from the sale of a security could be disallowed by the IRS if you buy back the same or a substantially similar security within 30 days.
But here’s the good news. The rules also allow you to sell one stock, and immediately buy back a similar stock in the same sector. For example, let’s take the endless debate of Coke versus Pepsi.
Let’s say you owned Coca-Cola stock earlier this year but were stopped out of the position during its decline in September. Buying back Coke shares within 30 days, or even buying a call option on the stock, could violate the wash sale rules.
But what if you’re also bullish on the prospects of PepsiCo? It’s a similar company in the same sector, but not substantially similar. After all, they’re different corporations following different business strategy. PepsiCo earns a good chunk of its profits from the Frito-Lay snack business, while Coke doesn’t have similar business interests.
So, replacing Coke with Pepsi in this scenario keeps your money invested in a high-quality consumer blue chip company. Plus, you still get to claim the loss on Coke to offset other gains this year.
I cannot stress enough that you should never let tax considerations be the primary driver of your trading or investing decisions. That said, being aware of the tax implications of the moves you make in your portfolio, and practicing tax-smart strategies when you can, will help you keep more of your gains in your brokerage account, instead of sending that money to the IRS.