Laura answers a listener's question about the best way to manage a losing investment.
Laura answers a listener's question about the best way to manage a losing investment.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Rannie, who says:
"I've loved your podcast since I found you last year! I have a question, and the answer may be helpful to others in my shoes. During COVID, I opened a brokerage account and budgeted $500 to invest in stocks--something that had long been on my bucket list and was a fun distraction. I chose carefully, and my investments were small since I wanted to have fun with no regrets.
I did pretty well with my stock investments, but one flopped. Stupidly, I was so sure that the price would eventually go back up that I bought more shares less than a year ago. Is there any tax benefit to waiting and selling the losing stock after I've owned it for a year? Would it change anything for my taxes?"
Rannie, thanks for your question! Investors will always have gains and losses. If you own a losing investment in a taxable brokerage account, you can sell it and get a tax break. This post will explain the capital loss tax deduction and how to use it to your advantage.
Welcome back, everyone, and thanks for joining me on episode 867! I'm Laura Adams, an award-winning author, finance spokesperson, money speaker, founder of The Money Stack newsletter, and host of the Money Girl podcast with 43 million downloads.
If you're getting value from the free content we love creating, consider submitting a 5-star rating or review on Apple Podcasts, Spotify, or wherever you're listening! If you have a question you'd like me to cover, please leave it on our voicemail line at 302-364-0308. You can also send an email and sign up for the free Money Stack newsletter at LauraDAdams.com.
RELATED: How can you reduce your taxes?
What is a capital gain?
When you sell any asset, such as a stock, index fund, or real estate, for more than you paid for it, you have a capital gain, which is taxable in the year of the sale. For instance, if you buy one share of stock for $50 and sell it for $75 in a taxable brokerage account, you have a $25 capital gain.
Remember that a capital gain is only taxable if you "realize" it by selling the asset. If you have an unrealized gain, also called a paper gain, it's not taxable. You can watch your asset appreciate and don't have to pay capital gains tax until you sell it.
Owning an asset for a year or less means you have a short-term capital gain, taxed at higher ordinary income rates, ranging from 10% to 37%, depending on your total taxable income. If you're a high earner, a short-term gain could even be subject to the additional 3.8% Medicare surtax.
However, after a year, you'd have a long-term capital gain, which gets taxed at a lower rate, ranging from zero to 20%, depending on your income. So, owning an asset for longer helps minimize your taxes.
What is a capital loss?
If you sell a capital asset, such as a stock or exchange-traded fund, for less than you paid, you have a capital loss. Again, you must sell the asset to have a capital loss. Rannie only has an unrealized loss until choosing to sell a losing stock.
However, if you sell an asset for a loss, you can claim a tax deduction up to an annual limit, reducing your taxes. How much you can deduct depends on your gains and losses and whether they're short- or long-term.
You must group your gains and losses by type. For example, short-term losses must first be deducted from your short-term gains. Long-term losses must be deducted against long-term gains. Then, net losses of either type can be deducted against the other kind.
As mentioned, short-term gains get taxed at higher ordinary tax rates. Therefore, selling
short-term assets at a loss when you have offsetting short-term gains or no gains at all, helps minimize your taxes. It also allows you to eliminate underperforming investments at the same time.
So, Rannie, if you're sure the losing stock needs to be eliminated from your portfolio,
selling it before a year is better than waiting for it to become a long-term capital loss.
READ ALSO: How do wealthy people invest money?
What is the capital loss tax deduction?
Let's assume your losses exceed your gains. For example, if you have $2,000 of short-term losses and $500 of short-term gains, the net $1,500 short-term loss can be deducted against your net long-term gain if you have one.
You can deduct up to $3,000 of capital losses from your annual taxable income, including your salary and interest income. And if you have an excess, you can carry it forward and claim it on a future tax return. So, selling a losing investment isn't the worst thing. Some investors choose to sell at a loss to offset their gains and strategically reduce taxes.
Note that there is an exception for your primary residence. You can never claim a capital loss when selling a home. But on the flip side, you may be eligible to exclude up to $250,000 or $500,000 if you file taxes jointly, of the capital gain on the sale of your primary residence. That's one of the best tax benefits that exist.
LISTEN ALSO: How to avoid capital gains taxes (legally) on your home sale
The difference between taxable and tax-advantaged accounts
Taxable brokerage accounts and tax-advantaged retirement accounts come with completely different rules. Rannie's investments are in a brokerage, which means selling them has tax consequences. With a brokerage, you must pay taxes on interest, dividends, and capital gains in the year you earn them.
The upside of a brokerage is that you can buy various securities whenever you want with no annual caps on the amount you can invest. You can sell your brokerage investments anytime with no penalty, regardless of age.
Retirement accounts have strict annual contribution limits, and withdrawals may come
with income taxes and early withdrawal penalties before the official retirement age 59.5. The upside of a retirement account is that your investment gains are tax-deferred with traditional retirement accounts or tax-free with a Roth.
In other words, there are no capital gains or losses in any type of retirement account. With a traditional IRA or 401(k), you pay ordinary income taxes when you take withdrawals in retirement instead of owing capital gains taxes.
With a Roth IRA or 401(k), you pay no taxes on withdrawals in retirement, even if the account actually has massive capital gains! That's why I always recommend you use a Roth for some portion of your investment portfolio.
Having a taxable brokerage and one or more retirement accounts is wise. You could use a brokerage for minimal trading, as Rannie did for fun. More importantly, you can use a brokerage to invest for medium-term goals, like buying a car or home in at least two or three years. Most offer low minimum deposits and a broad menu of investment options.
Retirement accounts give you a tax-advantaged way to save for the longest financial goal: retirement. But they don't have the flexibility of a taxable brokerage account. The best retirement accounts come from employers or are designed for the self-employed because they have high annual contribution limits, like a 401(k) or 403(b).
So, a workplace or self-employed retirement plan is the first place you should invest. Increase your contributions annually until you max it out. For 2024, you can put up to $23,000 or $30,500 if you're over 50 into most employer-sponsored retirement plans.
Self-employed retirement accounts, like a SEP-IRA or solo 401(k), allow higher contribution limits, if you have as much income. For 2024, you can put up to $69,000 in either type or $76,500 if you’re over 50 with a solo 401(k).
If you max out a workplace retirement plan or don't have one, use an individual retirement account or IRA next. For 2024, you can contribute up to $7,000 or $8,000 if you’re over 50 to a traditional IRA. You may be eligible for a Roth IRA if your income is less than an annual threshold.
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That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
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