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The average investor hates paying taxes—who doesn’t? And yet, long-term investors get some great tax breaks on both their profits and losses. The tax breaks make investing a better after-tax proposition than working for paid income. And at this time of year, investors should be looking at their capital gains totals because they may want to make some moves before Dec. 31st.
First, the bad news about capital gains taxes: if you make money on an investment and sell it, you have to share part of your profit with the feds and with most states. The good news is the tax rate: federal taxpayers will pay tax on capital gains at a lower rate than they do on their employment income. If you hold an investment for a year, your federal capital gains tax rate is just 15%. If your regular income tax rate is 15% or less, then your capital gains rate is just 5%. Compare that to federal tax rates as high as 35%. Also, there are no Social Security or Medicare taxes on capital gains. If you earn money at a job, as much as 7.65% of your pay goes to those taxes. So job income could cost as much as 42.65% in taxes, while capital gains go no higher than 15%. Some states also offer lower rates on capital gains.
So anyone who has a legitimate reason to sell an investment on which they have a long-term (more than one year) gain should not hesitate due to taxes. Investors who have a loss on their investments also get a break: you are allowed to deduct the loss against all current and future capital gains. And, if you don’t have enough current capital gains to deduct against, you can deduct up to $3,000 of other income each year. If you can’t use up this break in one year you can carry it forward and use it in subsequent years.
So someone who needs to make changes in their portfolio—whether to raise money for expenditure, or to rebalance the portfolio among various asset classes—should be looking right now at investments with losses and gains to decide what to sell before the end of the year. If you have losses, you can lock them in and use them against other gains or against ordinary income. You can even take a loss and immediately reinvest the proceeds, as long as you don’t buy the same security 31 days before or after your loss sale. However, you can reinvest in something similar as long as it is not substantially identical to the investment sold.