How your investments can save you money on taxes
This year, those of you with taxable investment accounts will receive a tax-reporting form from your custodian bank (such as Schwab, TD Ameritrade, Vanguard, etc). This form summarizes key information about your investments held there, as relates to your taxes.
This includes dividends, interest, capital gains (both short and long term), and capital losses (both short and long term).
Dividends and interest are relatively straightforward. You receive income and get taxed on it at the applicable rate. It's slightly more complicated than that, but your tax preparer will know what to do (whether you use software or a CPA). There's not much more you need to know.
Capital gains and capital losses are interesting though. And what makes them especially noteworthy in 2022 is something called "Tax Loss Harvesting." When you have a realized loss on an investment (ie, you sold it for less than you bought it for), you can use that loss to offset capital gains. If you don't have capital gains, or if you have more losses than gains, you can use $3000 worth of losses to reduce your "ordinary income." The rest of your losses get carried forward to reduce your ordinary income in future years. Again, by $3000 per year.
This is valuable because ordinary income is typically taxed at the highest rates. Ordinary income includes things like wages, distributions from pre-tax IRAs, rental income, and interest payments. All of which are pretty common.
So what's that worth? Suppose you're single, make $120,000 and are in the 24% tax bracket federally, plus 8.75% for Oregon income taxes. Combined, your marginal tax rate is 32.75%. If you're able to reduce your taxable income by $3000, that works out to $982.50 in tax savings. That lowers your tax bill by almost $1000. Imagine getting a refund check for $1000 more than you expected. That's pretty nice!
If this isn't something you're thinking about, you may open that 1099 from your custodian and think those capital losses are a BAD thing. But it's quite the opposite.
In fact, it's possible that your account hasn't lost nearly as much as the number on that form. I have a handful of clients whose investments are down slightly this year, but who were able to claim large amounts of tax losses. As hypothetical, but realistic example, suppose a client started the year with $725,000 and ended with $675,000, for an overall decline of $50,000. Depending on how their portfolio was constructed, they may be able to realize more than $50,000 in losses.
How does that work? Well, suppose that by the virtues of diversification, some things went up while other things went down. This was a relatively good year for energy stocks, for instance. Meanwhile, growth investments did poorly. The gains and losses on any investment also depend when the investments were bought. So there are a lot of factors determining whether something in your portfolio has a gain or a loss. All you need to know is that, even if the portfolio overall is down, there's a decent chance that a few of your investments performed well.
Here's where it gets interesting. You don't pay capital gains taxes on your investments until you sell them. And there's nothing saying you have to sell your winners anytime soon. So you can defer paying taxes on those for as long as you want.
With losing investments, however, you can sell them and then use that loss to offset other gains or ordinary income, like I mentioned earlier. Say you bought it for $10,000 and sold it for $8,000, for a $2000 loss. You still have $8000 cash in your account, which you can use to invest in something else. As an example, you could sell your Amazon shares, and buy shares of Apple. Whether Apple goes up or down in value, you can still claim that $2000 loss from Amazon on your taxes. Your overall allocation doesn't change that much, but you get a lower tax bill.
This is called, "Tax Loss Harvesting." You take capital losses as they arise, while deferring capital gains. As I said earlier, there's nothing saying you ever have to sell an investment. This gives you the flexibility to takes gains and losses at whatever time is most advantageous for you. Usually, that means waiting as long as possible to pay gains, while taking losses as soon as possible. The taxes saved give you more money to invest, or to enjoy life with.
When you get that 1099 form, I encourage you to think about taxes as their own separate consideration from investment performance. What you want to see, ideally, is a very large column of realized losses, and a very small column of realized gains. That gives you more opportunities in this year, and in future years, to reduce your tax bill.
Which is nice.