Don't Mess With Taxes

Donald Trump's touted tariff Liberation Day turned into a dark day after for U.S. investors. (Autopilot via Wikimedia)

How are my fellow investors doing this day after Liberation Day? Yeah, I thought so.

When the markets opened today, we got to see the real time reaction to Donald Trump’s expansive round of tariffs he announced late Monday, April 2, afternoon. It wasn’t pretty.

The global trade move sparked a Wall Street dive to its worst day in five years. That prior low also was under a Trump presidency, as we were starting to feel the initial economic effects of the COVID-19 pandemic back in June 2020.

Although the Trump administration insists the economic pain will be short-term and the United States’ economy will rebound stronger than ever, that’s definitely a hard sell right now. Investors today exited the markets in droves.

I’m not questioning anyone’s financial strategies or risk levels. We’ve all got to do what we believe is correct for our current and future money circumstances. Only time will tell, for investors who have the time, whether selling now or toughing it out during this scary patch was the right move.

But those who sold today at a loss might see a benefit next tax filing season. They can use their losses to offset any capital gains they might have this tax year.

This technique is known as tax loss harvesting, and it’s usually done in more pragmatic, less volatile circumstances. But again, all investors work in their own ways.

Here’s a look at how it might save sellers some tax dollars.

Capital gains and losses overview: The obvious goal of investing is to make money. Even if we ultimately owe tax on those investments it’s worth it because, well, money.

The good news is that profits from long-term investments, those assets you hold for more than a year before you sell them, typically are taxed at lower rates.

The three capital gains tax rates (0%, 15%, and 20%), and the income brackets to which they apply for the 2025 tax year (they are adjusted annually for inflation), are shown in the table below.

  
If you sell a capital asset after owning it for only a year or less, that’s known as a short- investment. These short-term profits are taxed at generally higher ordinary income tax rates. That’s what we pay on our salaries, with the seven tax rates ranging from a low of 10 percent to a high of 37 percent.

So, it’s better if you can hang onto an asset long enough to get the long-term tax rate on any sale profits. And it’s better to pay no tax at all. That’s where tax loss harvesting comes into play.

Stay or go, your choice: When you sell investments at a loss, you can use those losses to offset gains you recognized from other investments. You then can take the money from the sale and use it to buy an investment that fills a similar, but not identical, role in your portfolio, so you stay invested in the market.

Or, if you just wanted to be done with the losing asset, you at least have the tax benefit of using its losing sale amount to counter your profits.

If you don’t have any capital gains to offset, you can use up to $3,000 against your ordinary income. You can carry losses of more than three grand forward into future tax years until you use up the loss amount.

Quick aside for some unsolicited investing advice. If you have no gains to offset in the initial or subsequent tax years, consider getting a different investment adviser. Now back to tax loss harvesting.

Review your overall portfolio: Under less dramatic circumstances than the Trump tariffs’ effect on the market, an investor’s first move is to not act emotionally or rashly.

We’re well past that point for some of you. Again, no judging. But if you haven't yet sold everything, take a look at your complete holdings. Today’s stock price drops could be a chance to not only harvest them for tax purposes, but also rebalance your portfolio.

That’s a good move any time that all or most of your holdings are in the same sector(s). Maybe it's a good time to diversify. In addition to being an opportune time to dump assets that have lost value, you can buy some at bargain prices to bulk up your investments in an area you had ignored.

Begin with basis: Remember, you're looking at the amount of value lost. That starts with knowing your assets' basis.

The down and dirty basis calculation is the price you paid for the asset, adjusted by any commissions you paid, along with reinvested dividend and capital gains distributions on which you paid tax in earlier years.

For mutual funds, the average cost basis method is the one most often used. Here all your purchase prices are, as the name says, averaged together. Your broker or the fund company should be able to help you with the basis amounts.

You then take the price you got for your sale, and subtract your basis. When it's a loss, that amount can be used to offset any gains you have for the tax year.

A quick note here. It is possible for the market to go down, and you still realize capital gains. This sometimes happens to mutual fund investors. In this case, capital gains aren't necessarily connected to the market's overall performance. Rather, the gains are determined by the sale of securities within the fund throughout the year.

That means that even when markets are down, such security sales still can create a gain. And those gains must be paid out to shareholders at least once a year. Hence, those year-end fund statements with the previously mentioned capital gains distributions, which sometimes are surprising large given the way the markets went.

These payouts are more common in actively managed equity mutual funds. Again, this is a good reason to review your portfolio at least annually and decide if these types of taxable payouts are what you want at this point in your investing life.

Calculating your loss: If you have realized or expect such fund gains, your capital losses from your sales now can counter them. Here's a very basic example, excluding basis adjustments:

You bought 100 shares of Stock XYZ in 2015 for $100 per share. Your original purchase price was $10,000. XYZ's current price now is $25 per share, so you sell it all, netting $2,500. Your sale proceeds of $2,500 minus your original price of $10,000 gives you a $7,500 capital loss.

You can use that $7,500 in long-term capital losses to zero out any corresponding long-term capital gains this year, reducing your overall tax bill. And, as mentioned earlier, if you have more capital losses than gains, you can use up to $3,000 against ordinary income.

Don't tax wash your holdings: You decided to take a loss on an asset, but you really like its longer-term outlook. You want to buy some of it back, or another asset that's essentially the same.

Stop! Doing that will run you afoul of the wash sale rule.

The Internal Revenue Code wash sale rule says you cannot take tax advantage of a losing asset and then repurchase substantially the same stock within 30 days of the sale. This 30 days actually is 60 days, because it applies to 30 days before the sale and 30 days after the sale.

Basically, Uncle Sam's tax code doesn't allow you to sell a dog of stock solely to get a tax break.

The wash sale implications are obvious when you sell XYZ, take the loss, then buy more shares of the now cheaper XYZ. But what about XXYYZZ, which is the same type of asset?

The key descriptor here, as mentioned earlier in this post, is substantially similar. And what's that? As I note in my book, The Truth About Paying Fewer Taxes, as in many tax situations it depends.

The Internal Revenue Service says you must consider all the facts and circumstances in your particular asset sale case. So do your due diligence, which is a good idea any time you're investing.

And in this case, it’s definitely worth talking with financial and tax professionals to ensure you don’t end up talking later to an IRS auditor.

Tax-deferred retirement accounts don't count: Many folks' connection to the markets is through their retirement accounts. If that's your case, you’re out of luck as far as tax loss harvesting. This tax/investing strategy is for taxable assets, only.

If you have a traditional IRA or 401(k) plan, those accounts are tax-deferred. If they've lost value, you can't take the distributions, i.e., sell them without taking a tax hit on the earnings.

And if you're younger than 59½, you'll also face an early withdrawal penalty. So you’re going to have to just gut it through this market drop.

However, now could be a good time to consider converting your traditional IRA to a Roth IRA. My earlier post — The down market could make it a good time to convert a traditional IRA to a Roth — has more on this option.

But when it comes to basic tax loss harvesting, you must focus on your asset holdings that are taxable.

Breathe. Review. Take another breath: Yeah, I know you want to jump out of the market right now. And doing so could provide you some tax benefits.

But don't make any financial decisions based solely on the tax implications or consequences. Do what is right for your long-term fiscal well-being, and if there are tax breaks, be sure to claim them.

You also might find these items of interest:

• Capital gains tax rate is higher on sales of collectibles
• Donating appreciated assets is an alternative way to give to charity
• Texas man charged in apparent first-ever criminal crypto capital gains tax case

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