- Tax lots include all transactions involving a particular security in a portfolio (dates of purchase and sale, cost basis, sale price).
- When deciding what assets to sell and when in a tax year, an investor can think in terms of tax lots.
- It is especially important to consider how you choose to calculate capital gains and losses and how taxes will be charged on those investments based on your choice of cost basis method.
A series of tax bills, topped off by the Tax Cuts and Jobs Act (TCJA) of 2017, have recently given investors a great chance to save money on long-term capital gains and dividends. The best way to maximize the benefits of these changes is to use tax losses in managing your investment purchases and sales, and to report that income to the Internal Revenue Service (IRS).
For tax purposes, the amount of securities purchased in one transaction constitutes a “lot.” In a tax lot, all transactions involving a certain security are recorded (dates of purchase and sale, cost basis, sale price) and their tax implications. An investor can lower his or her tax liability by considering tax lots when making strategic decisions about which assets to sell and when.
What are the current tax rates?
As of the date of this article, Congress is proposing significant changes to these rates that could increase them. The current rates were instituted by the Tax Cuts and Jobs Act and are expected to remain in place until 2022. It is important to stay abreast of these proposals for tax planning purposes if passed in its current form. You can find the latest information on the Tax Foundation website.
Those who earn over $445,850 in income in 2021 will be subject to a 20% tax on long-term capital gains; those filing jointly will be subject to a $501,600 tax. Those who earn between $40,400 and $445,850 ($80,800 and $501,600 for couples) are subject to a 15% tax rate, while those earning under these minimums are subject to a 0% tax rate. A filer must have owned the investment for at least one year in order to qualify for these rates.
In the Act, seven income tax brackets were established, ranging from 10% for low-income earners to 37% for top earners. Short-term capital gains, long-term capital gains, and dividends are taxed based on your tax bracket. Below you will find out how your dividends, short-term capital gains, and long-term capital gains will be taxed.
Taxpayers with higher incomes may have to pay an additional 3.8% net investment income tax on top of the rates listed in the table.
This chart illustrates that short-term capital gains receive the worst tax treatment and should be avoided if possible. Note that qualified dividends are the only ones that qualify for the reduced tax rate. Unless the dividend is received on a security held at least 60 days during the 121-day period beginning 60 days before the ex-dividend date, the reduced rate will not apply.
Gains and Losses: How to Report
For tax purposes, Form 1099-DIV separates ordinary dividends from qualified dividends. The form called Schedule D-Capital Gains and Losses asks you to keep track of the original cost basis of the securities you acquired in order to report short-term and long-term gains for the year.
The short-term gain and loss are netted first, followed by the long-term gain and loss netted. In order to calculate your overall capital gains, you must be careful not to violate the wash-sale rule, which prevents you from claiming a loss if you bought the same security within 30 days.
Taking advantage of tax lots
When you sell shares, you should understand how your cost basis affects capital gains and losses.
- According to FIFO, the first one to arrive is the first one to leave
- A method based on average costs
- Specified-share method
In order to calculate the value of individual stocks and bonds, you can use:
- Last in, first out (LIFO)
- Method of specific shares
In most software packages, the default FIFO method is used, and it is convenient for tracking costs. Selecting specific tax lots is about minimizing your gains when compared to those standard FIFO or LIFO methods. This is what it means to select specific tax lots.
Consider, for example, a two-year period during which you purchased the following stock in the 32% tax bracket.
A long-term gain of $20,000 would result from selling the 800 shares you purchased two years ago under the FIFO method, resulting in a tax bill of $3,000. Even if you held your most expensive shares for a short period of time, you may be able to sell your most expensive shares first, and still have a lower tax bill of $2,140 if you choose to sell a specific tax lot.
If you keep accurate records and sell your highest-cost positions first, tracking securities by tax lot is an excellent way to minimize the taxes you owe on your gains.
Tax minimization methods include:
- In general, avoid short-term gains. However, if the cost of the new position is lower, selling it first can sometimes be a good idea.
- Stocks and funds with high turnover cost you more in commissions, transaction costs, and tax liabilities. If you plan to trade a lot, make sure that every decision is tax-efficient.
- Invest in tax-managed funds. These funds are structured to minimize taxes for investors. Their managers invest in the same stocks as other funds, but spend less time buying and selling within the fund to minimize year-end distributions of capital gains.
- Losses can be harvested and used to offset future gains. Make sure your losses carry forward to future years.
When you sell a security, you can determine your gain or loss in a variety of ways. It is important to choose a method that works for you and stick with it. While first-in, first-out might be the simplest method to calculate and track, it might not always be the best method.
Your broker or custodian should acknowledge your selling instructions in writing if you use the specific-shares method.