Sunday, December 25, 2011

End of the Year Losses

Merry Christmas everyone and thank you for supporting me in reading my blog.  While you open those expensive family presents you bought each other (which hopefully you have budgeted), I thought I'd end this year with an educational post about what almost everyone does near December 31st: take capital losses to offset any capital gains or some income.  The reason why you would want to offset capital gains or income is to save on taxes.

First off, what exactly is a capital gain?  I mention this in one of my earliest posts about stocks, but as a refresher, capital gains are the gains in value you make after buying a stock at a low price and selling it at a higher price.  If you had 10 shares of XYZ, spent $100 purchasing them, and sold them for $200, you would have a capital gain of $100 ($200-100 = $100) or 100% (($200-100)/100 = 100%).  However, this is not the actual amount you will get net of taxes since you will have to pay taxes on this amount.  Capital gains are separated into two categories: short-term capital gains and long-term capital gains.  If you hold a security for more than a year before selling it, any capital gains (or losses) are considered long-term.  If it has been less than a year, then any gains or losses after selling are considered short-term.  Short-term gains are taxed at ordinary income rates (meaning if you have enough income to fall into a higher bracket, you would be charged that tax rate on that capital gain).  If you wait a year before selling your security though, any gain you get will be considered a long-term capital gain which gets taxed at 0% if your total income falls in the 10% or 15% tax brackets and at 15% if your total income falls in or above the 25% tax bracket.  This means a minimum of 10% savings in taxes if you hold onto your security for more than a year before selling.

If you take a capital loss, you can offset any capital gains you had during the year.  Obviously, if you fall in the 10% or 15% brackets and realize only long-term capital gains, you are already taxed at 0% and don't have an incentive to sell losing positions (other than saving money if you believe the stock will continue to underperform).  However, let's continue the example before with your $100 capital gain.  Let's say it was short-term and you sold the stock after only 3 months.  Let's say you also hold 10 company ABC shares which you bought for $270.  This stock didn't do as well and is now currently worth $200 if you decide to sell them.  If you do, then you would realize a loss of $70 ($270-200 = $70).  You can use this amount to offset your $100 capital gain giving you a $30 net capital gain ($100-70 = $30).  Now you will only have to pay taxes on $30 rather than $100.

You can also use capital losses to offset part of your income.  From the IRS website, "If your capital losses exceed your capital gains, the excess can be deducted on your tax return and used to reduce other income, such as wages, up to an annual limit of $3,000, or $1,500 if you are married filing separately" so make sure to take advantage of capital losses when you have capital gains that year.  If your capital loss is more than any capital gains you have and you have met the maximum you can offset for your income, you can still carry over capital losses to next year and treat it as if you incurred it that year.  However, you cannot use current capital losses to offset capital gains in previous years.

Timing can be critical in tax savings depending on when certain events happen relative to the calendar year.  Many investors and ordinary households sell losing stocks to get some of those tax savings and you can use these strategies too to lower your tax bill come April.  Of course, also don't sell blindly just to get capital losses on your tax statement.  A lot of people do this since this is such a popular strategy and this makes some stocks or funds more attractive at this time of the year (so there might be some good bargains if you are looking to park some money somewhere with relatively easy gains).  You may want to be on the lookout for undervalued companies who have been through a lot but look well-positioned for 2012.

Well again, Merry Christmas everyone and I hope you all enjoy your holidays.

1 comment:

  1. Hi, I came across your site and wasn’t able to get an email address to contact you. Would you please consider adding a link to my website on your page. Please email me back.

    Thanks!

    Harry
    harry.roger10@gmail.com

    ReplyDelete