Trying to decide whether and when to sell a stock these days may seem confusing enough in the face of the volatile stock market without having to worry about the tax impact.
But there are some important tax consequences to consider before deciding when to cash in profits or take losses.
– Tax incentive to wait. For example, if you’re thinking about selling a stock or mutual fund that’s gone up in price, there is incentive to wait until you’ve owned the shares more than one year. Your gains will be taxed at a lower rate.
Thanks to the IRS reform bill recently signed into law, investors no longer have to wait until they’ve owned the shares more than 18 months to qualify for the lowest capital-gains rates. The legislation eliminated the 18-month holding period retroactive to the beginning of this year. As a result, you’ll qualify for the lowest rate as long as you owned the stock more than 12 months.
And there is plenty of incentive to hang on that long. Profits from investments held one year or less are taxed just like wages at regular rates of up to 39.6 percent. By contrast, stocks held more than one year are taxed at a top rate of only 20 percent. (For investors in the bottom 15 percent tax bracket, investments held more than one year are taxed at a 10 percent rate.) Waiting to qualify for the lower tax rate can result in substantial tax savings, particularly if you’re cashing in large gains.
For investors in the top tax bracket, waiting would cut the capital-gains tax in half. On a $10,000 stock market gain, being able to pay tax at a rate of 20 percent instead of 39.6 percent would mean a tax bill of $2,000 instead of nearly $4,000.
For an investor in the 28 percent tax bracket, waiting would slash the capital-gains tax bill by nearly a third–to $2,000 from $2,800, a savings of $800.
But those tax savings are based on the presumption that the price of your stock will hold firm between now and the time you qualify for the lower capital-gains rate.
If you’re nervous the price of your stock could slip, waiting to sell is a risky gamble, particularly at a time when the stock market is so volatile. In fact, many investors are likely to be surprised at how little a slip in the stock price it takes to offset the potential tax savings from waiting to qualify for the lower capital-gains rate.
To illustrate, say an investor in the top tax bracket owns 500 shares of stock that he bought for $40 a share 10 months ago and which are now selling for $50 each. By waiting another two months to sell, he’d save as much as $980 in taxes on the $5,000 profit–presuming the stock price held firm at $50.
But if the stock price were to drop by just $2 a share–from $50 to $48–the investor would end up worse off for waiting. It would take an even smaller drop in the stock price to offset the tax savings if you’re in a lower tax bracket.
So before deciding whether to wait to qualify for the lower capital-gains rate, be sure to calculate how far your stock can drop before the tax savings are wiped out. And then assess the risk that your stock will drop that far.
– The hidden bite. Because of some new wrinkles in the tax law, figuring the full tax impact of an investment sale requires looking at more than the holding period and the capital-gains rate you’ll be taxed at. You’ll also need to see whether an investment sale will spoil your chances to claim some valuable new tax breaks created by the Taxpayer Relief Act of 1997.
Most of the new law benefits are subject to income-eligibility requirements. Among them are the new family tax credit of up to $400 per child under age 17, two tax credits for college tuition, the new student loan deduction and the new Roth IRA.
If you’re bordering on the income-eligibility limits for one of the breaks, cashing in a large stock-market gain could push your income above the income cutoffs and end up costing you hundreds or even thousands of dollars in tax benefits.
For example, say you have a child who is a sophomore in college, making you eligible for the new Hope Scholarship credit of up to $1,500 this year. The tax credit starts to phase out for taxpayers with adjusted gross incomes above $80,000 on a joint return and is unavailable for incomes above $100,000. If your adjusted gross income is now projected to be $80,000, be aware that any profitable investment you decide to sell this year will reduce your eligibility for the $1,500 credit.
– Salvation for losses. It’s never easy to admit a mistake and pull the ripcord on investments in which you’ve lost money. No one likes to sell at a loss.
But the tax code does provide some salvation if you do decide to bail out of a stock before it has a chance to drop even further. Your losses can be used to offset any capital gains you have, plus up to $3,000 of other income, such as salary from your job. (Any excess losses can be carried forward for use in a future year.)
The losses will be most valuable if you’re able to use them to offset short-term capital gains or salary that would otherwise be taxed at regular rates of up 39.6 percent.
The losses could turn out to be even more valuable if you’re bordering on the income-eligibility limits for one of the new law tax breaks. Capital losses will reduce your adjusted gross income.
– “Wash-sale” rule. What if you have a big paper loss in a stock but are hopeful that the stock will go back up? Why not just sell the shares so you can write off the losses and then immediately buy replacement shares of the same stock?
Unfortunately, Congress slammed the door on such scheming long ago. The tax code contains a restriction known as the “wash-sale” rule. Under this rule, the IRS will disallow your loss if you buy shares in the same stock within 30 days of the sale.
