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Making the Most of Your Capital Losses

Long-term capital gains are taxed at a lower rate than most other forms of income. Specifically, they are taxed at:

  • A 0% rate if they fit into the 10-15% income tax brackets,
  • 15% if they fit into the 25-35% tax brackets, and
  • 20% if they end up in the new 39.6% tax bracket.*

As a result, when you have capital losses, it’s ideal when those losses can be used to offset ordinary income such as wages (given their relatively higher tax rate) rather than capital gains (given their relatively lower tax rate).

However, in a given year, your capital losses are first used to offset your capital gains. It’s only when your losses exceed your gains that you can use them (subject to a $3,000 limit per year) to offset ordinary income.

Therefore, it can sometimes be beneficial to avoid realizing capital gains and losses in the same year.

For example, if you sold a stock for a $5,000 capital gain this year, and you have another stock (that you plan to eventually sell) that currently has a $5,000 unrealized capital loss, you may want to wait until next year to sell the other stock, so that you can pay the low tax rate on your capital gain this year, then use your capital loss to offset ordinary income over the next two years.

And conversely if you have realized capital losses this year, you may want to wait until next year to realize capital gains (thereby allowing $3,000 of this year’s capital losses to offset ordinary income).

There Are Exceptions!

Due to the annual $3,000 limit on the deduction for net capital losses, the total savings for this strategy is limited to a few hundred dollars per year (specifically, $3,000, multiplied by the difference between your marginal tax rate for ordinary income and your marginal tax rate for long-term capital gains).

In other words, while it’s helpful to keep this strategy in mind, there will often be other considerations that are more important.

For example, if a few individual stocks make up a huge portion of your overall portfolio, it could very well make sense to sell all of them sooner rather than later so that you can diversify your portfolio as quickly as possible — even if doing so is not the most tax-efficient approach.

Or, if you have sold some investments for gains this year, and you have an unrealized capital loss that’s so big that it will not only offset this year’s capital gains, but also provide for many years worth of $3,000 deductions, you may want to just go ahead and take the loss now.

*If your modified adjusted gross income is $200,000 or more ($250,000 if married filing jointly), your capital gains will also be subject to the new 3.8% Medicare surtax on net investment income. But even still, your marginal tax rate for long-term capital gains will be less than your marginal tax rate for ordinary income.

For More Information, See My Related Book:

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Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

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Comments

  1. We’re currently carrying a ton of losses from some tax loss harvesting during the recent down times and have been using it to offset $3k of ordinary income every year. As you point out, the $3k limit means that it doesn’t have a huge impact, but it’s nice annual savings. Unless we realize some large gains, we’ll be able to do this for years to come.

  2. Does “ordinary income” subject to the $3K annual offset include ordinary (not qualified) dividends (from stock or bond funds) that are taxed at ordinary income rates?

    In other words, if I’m retired (early) and living solely off of investment income (dividends + capital gains from taxable (non-IRA) accounts), can I offset ordinary dividends with capital losses? Didn’t think I could.

  3. Steven,

    The $3,000 amount for net capital losses is just a plain-old deduction. It shows up on line 13 of Form 1040. In other words, it should be able to offset any taxable income that you have.

  4. Yes, what Mike said. It’s quite nice, though I wish it was more than $3k. At the very list, they should index it to inflation.

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