Since this is the time of year for filing tax returns and paying Uncle Sam is on everyone’s mind, it is a good time to talk about capital gains on investments. Most people know that in taxable accounts when you sell a security for more than you paid for it, you pay tax on the increase. If you hold the investment for more than a year, it is considered a long term capital gain and you pay a lower tax rate than you would on ordinary income, either 15%, 20%, or zero depending on your adjusted gross income.
But what happens if you bought the security over time and not all at once, and then sell part of it? There are a few methods on how you can account for this, and some are more tax beneficial than others. In the past, you kept records of the cost basis and your tax preparer sorted it all out. But in 2011 the IRS started requiring brokerage firms to track cost basis.
One consequence of this change is that decisions about which shares to sell need to be made when a security is sold, not at the time your tax return is prepared. It is important that whoever is making the sale of a security (your investment advisor, you, or your broker) understand this and have a strategy on how to sell different “lots” of a security.
Here is our general approach to selling security lots for clients. We sell lots at the top of the list first and working our way down the list:
Tax Lot Optimization Priority Rank
I said this is our general approach because some situations dictate different approaches. For example, you may have a lot that has a small short term gain and another lot that has a huge long term gain. In this case you probably want to sell the short term gain lot first, because even though it is taxed at a higher percentage the overall tax could be a lot less. Or you may be in a low enough tax bracket that the capital gains rate is zero, and you could sell a long term gain lot instead of one with a loss.
Here is the key point: taxes are the biggest investment expense an investor pays. It is important to consider the tax impact of investment moves before selling, not when you file your tax return.