Tax-Smart Investing in a Volatile Market
In a year of extreme economic change, it may be hard for investors to decide what to do when it comes to balancing gains and losses and reporting those fluctuations to the IRS. Learn about the difference between paper losses and actual losses, how they differ between tax-deferred investment plans and taxable investments, and how you can use tactics such as offsetting gains and losses to manage your risk.
A volatile market
The coronavirus pandemic abruptly forced many areas into lockdown and resulted in millions of job losses, business closures, and strained wallets. The stock market took immediate notice and sold off in dramatic fashion, reflecting this market volatility. Investment balances held in tax-deferred investment plans, tax-free Roth accounts, or taxable brokerage accounts fell significantly, possibly resulting in losses for some.
If you were a first-time investor who held investments in taxable accounts and decided to sell in reaction to this volatility, you may have experienced taxable gains or losses after these share price fluctuations. Keeping track of these trades will be important once it's time to report your transactions on your tax returns.
If you want to avoid paying too much in taxes from capital gains, there are a few useful strategies you can use to offset your tax bill. To learn more about how you can balance reported gains and losses, let's review some investment tax tips for a volatile market.
Paper losses vs. actual losses
When you buy an investment and later sell it for a lower value, you "realize" a loss. These realized losses count as actual losses. Conversely, if you still hold the investment but it is worth less than you originally paid, you would have a paper loss. Only when you sell for a lower price do you convert your paper loss to a realized loss.
If you dispose of this investment in a taxable account, you may be able to claim a deduction against other gains or some of your income. The type of loss depends on the holding period, or the time between purchase and sale.
When you lose money on investments held for a year or less, you typically have a short-term capital loss. For investments sold below what you paid after a year, you have a long-term capital loss. If you need to report these losses, they will appear on Schedule D, Capital Gains and Losses.
Investors can use capital losses to their advantage by offsetting their reported income on Form 1040. You can typically use any realized loss to net against a realized capital gain in the same tax year, but you can only claim up to $3,000 as a deduction against your other income per year.
Any unapplied loss rolls forward to future years to offset future capital gains or up to $3,000 per year in other income.
Reporting investment gains and losses
When you need to report investment gains or losses, that means you've taken an action to sell investments from your portfolio which had paper gains or losses. This converts them to either realized or recognized gains and losses.
If you made these transactions in a taxable account, you'll recognize a gain or loss and need to report it to the IRS on your tax return. In tax-free or tax-deferred investment plans, you only realize a gain or loss but do not experience a tax impact.
Therefore, recognized gains and losses get reported in the year the transactions occur, while realized gains and losses that are not recognized occur on the actual sale of an asset but do not get reported to the IRS.
In a year with significant market volatility, the gains or losses you report depend on the transactions you made. If you made several purchases that you then sold at a loss, and these losses are greater than any other gains, you might have capital losses that get carried forward to future years, unless you can offset your recognized gains throughout the year.
On the other hand, if you had a favorable year and have a significant amount of gain which you cannot offset with matching losses or carried-over losses, you will likely need to pay capital gains taxes. The income tax rates you pay partially depend on the holding periods of your investments.
Tax-free and tax-deferred investment plans
If you made trades with the investments held inside tax-free or tax-deferred investment plans, you won't need to worry about this year's market volatility from a tax perspective. For tax-free plans, you pay taxes on your contributions upfront, meaning you won't pay taxes on gains realized inside your account.
For tax-deferred investment plans, your contributions are typically deducted from your income before being taxed, so you won't pay that tax until you begin to draw your distributions. Market volatility may have led you to make changes to your investment portfolio, but you usually won't face tax consequences for making these investment decisions.
Also, if you want to minimize the taxes you pay on your investment gains from taxable accounts each year, you can reduce your portfolio turnover. This will result in fewer trades and, therefore, fewer taxable events each year.
Tax-loss harvesting can offset losses
Economic fluctuations can be unnerving for your investment portfolio. When you see your account numbers teeter and concerning headlines appear, you may worry about losing money. If you ignore the market's movements and your investments regain their value, you would likely only experience paper losses and could still end the year in positive territory.
Some may have used the market volatility as an opportunity to reduce their tax bill by offsetting gains or income using a strategy called "tax-loss harvesting." This is a method for offsetting gains with losses. While losing money in an investment is never ideal, it might not be quite as bad when you recognize the loss and use it to offset recognized gains you've had on other investments or income.
Essentially, tax-loss harvesting allows you to sell investments that have gone down in value and replace them with new ones but not the exact same investment. This is called a “wash-sale” and you will not be able to recognize the loss unless you wait long enough after selling it to buy it back. You can however make another investment that is similar. This then offsets recognized investment gains with those losses while keeping roughly the same investment portfolio. This can result in less of your money going to taxes and more of your money staying invested. Doing this can help you reach your financial goals faster.
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