Tax Planning 101 for Stocks

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Tax Planning 101 for Stocks

You can follow a few basic planning strategies for stock investments held in taxable accounts. However, you should keep in mind that your goal as an investor should be to achieve the highest aftertax rate of return, not to avoid paying taxes. Taxes are a consideration, but they should not control your investment decisions.

The value of deferral and stepped-up basis

All things being equal, it is better to pay taxes later than sooner. Therefore, you should endeavor to defer taxation as long as possible. An investor who purchases the shares of sound businesses and patiently holds them will not only enjoy the benefits of tax-free compounding, but will also save on brokerage commissions. At the least, toward the end of the year, you should consider delaying the realization of capital gains until January to defer your tax liability until the following year.

If you are extremely patient and die still owning a stock, your beneficiaries will receive the stock with a "stepped-up" basis, or a basis equal to the market value on the date of your death. Your beneficiaries can then sell the stock and owe no tax on the capital gains accumulated during your lifetime.

Wait for long-term capital gain treatment

Purchasing a stock on Jan. 1 and selling it for a gain on Dec. 31 of the same year is likely not to be a smart tax move. In this case, your capital gain is short term and taxed at ordinary income rates. Had you sold the same stock a few days later on Jan. 2 of the following year, the gain would have been treated as long term and taxed at lower long-term capital gains rates, and in addition would be delayed another year.

Take short-term losses

If you happen to have both short-term and long-term capital gains, you may want to consider realizing short-term capital losses on stocks you have held for less than one year. These short-term losses will offset your short-term gains, which are taxed at higher ordinary income rates. This will give you the most tax mileage for your capital loss.

Timing capital gains and losses

When faced with large capital gains and losses, it may be advantageous for you to realize both in the same year. Suppose you have $30,000 of capital gains and $30,000 of capital losses. If you realize only the gain this year, you will have to pay tax on the entire $30,000. If you decide to realize only your loss, you’d have no capital gains to offset it, and you could deduct only $3,000 against your other income. The remaining $27,000 loss must be carried over into future years. Instead of delaying the tax benefits of your loss, you could choose to realize both the capital gain and loss in the same year. Since they completely offset each other, you would not owe any taxes.

On the other hand, if you do not have a large capital loss to offset, you should generally time the realization of long-term capital gains—which will be taxed at favorable rates—for years when you do not realize any capital losses. Then you can realize your future capital losses in years when you can immediately deduct them against other income that may be taxed at higher ordinary income rates.