With the new tax lot accounting rules taking effect this year, getting more in depth with the tax lot accounting methods was necessary. In the past you could crunch the numbers at years end, to figure out the lowest possible taxes on your stock sales. As of January 1st, you’ll need to know how to calculate tax basis for each investment at the time of sale.
Throughout the year, keeping track of each stock sale (profit and loss) will be a requirement, in order to minimize your taxes at the end of the year. Online brokers are now required to keep track of your realized gains and losses throughout the year. You can use a simple spreadsheet to do the trick as well.
By tracking each stock sale throughout the year, you’ll be able to use the best tax lot accounting method to keep your taxes as low as possible. Remember though, that the type of tax you pay will depend on how long you have owned that stock.
Capital Gains Tax
When you sell stocks for a profit the IRS gets their cut and you keep the rest. The amount the IRS gets is determined by the length of time you owned the stock and your income tax rate. As far as income tax rates are concerned you’re in one of the following: 10%, 15%, 25%, 28%, 33%, or 35%.
There are two types of capital gains tax, short-term capital gains and long-term capital gains.
Short-term capital gains are taxed at your ordinary income tax rate and are defined as investments held for a year or less before being sold.
Long-term capital gains are defined as investments held for longer than a year and are taxed at a lower rate than short-term capital gains. For 2011 and 2012, if your income tax rate is 10% or 20%, your long-term capital gains will be 0%. If your income tax rate is 25% or higher, your long-term capital gains will be 15%.
What does all this mean? Whether you own a stock for one minute or 365 days, if you make a profit, it’s taxed the same as your income. If you own the same stock for 366 days or longer, it will be taxed at 0% or 15%, depending on your income tax rate. The possible savings associated with long-term capital gains can be tremendous, but it should not be a factor when deciding whether to sell a stock.
Selling For A Loss
Not every investment is profitable, stocks don’t always go up and selling for a loss can be a good thing when it comes to your portfolio as well as your taxes. There are two reasons to sell a stock for a loss.
The first and best reason to sell a stock for a loss is simply because it’s a bad stock that won’t make you money. It’s better to sell it, than to hold on to the stock, hoping you’ll make your money back.
The second reason to sell a stock for a loss is simply for tax savings purposes. When you sell a stock for a loss, it offsets any profits you make from your investments that year. It’s a commonly used tax planning strategy, especially towards the end of year, to lower your taxes for the year.
You have to watch out for the wash sale rule whenever selling a stock for a tax loss. The IRS has put restrictions in place regarding stock sales for a loss. Under the wash sale rule, your anticipated loss is not allowed if you buy shares of the same stock within 30 days before or after the loss transaction. The easiest way to avoid a wash sale is to buy stock of a similar company after the loss sale.
Understanding the tax implications when you sell a stock will make choosing the right tax lot accounting method much easier. In the second part of this article we’ll explain the different tax lot accounting methods available and how each method can help (or hurt) your overall taxes.