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Tax Guy: I’ve had crazy swings in my investments this year. What’s the tax impact ?

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If your investments have swung wildly up and down this year, join the club. You may have already recognized some significant gains and some significant losses —especially if you’ve been buying the dips and riding the elevator back up before selling. Then starting all over again. 

In any case, nothing is decided tax-wise until yearend when the final results of your trades will impact your 2022 tax situation. 

Here’s what you need to know to avoid an unexpected tax outcome. I’ll start off with something that you almost certainly already understand, but you know what happens when we assume. So, onward. 

Investments held in tax-favored retirement accounts 

If you’ve had wild swings in the value of investments held in a tax-favored account like a 401(k), traditional or Roth IRA, or self-employed SEP account, those wild swings have no current tax impact. It doesn’t matter if the swings are from executed trades or from fluctuations in the value of investments that you still hold. While the swings affect your account value, they have no tax impact until you finally start taking withdrawals. At that point, a higher account value will result in more taxes as you liquidate the account, and a lower account value will result in lower taxes. If you have a Roth IRA, qualified withdrawals taken after age 59½ will be federal-income-tax-free regardless of how much your account is worth.

Investments held in taxable accounts            

Tax-wise, your cumulative gains and losses from executed trades during the year are what matter. Unrealized gains and losses (paper losses) don’t affect your tax bill, although they can certainly affect your mental health.  

Overall loss for the year

If your losses in taxable accounts for the year exceed your gains, you have a net capital loss for the year. Sorry about that. Here’s the drill to figure out the tax results.

Step 1: Divide your gains and losses into short-term gains and losses from investments held for one year or less and long-term gains and losses from investments held for more than one year. 

Step 2: If your short-term losses exceed the total of your short-term and long-term gains, you have a net short-term capital loss for the year.

Step 3: If your long-term losses exceed the total of your long-term and short-term gains, you have a net long-term capital loss for the year.

Step 4: Claim your allowable net capital loss deduction of up $3,000 or up to $1,500 if you use married-filing-separate status. First use the deduction to reduce your net short-term capital loss from Step 2. Use any remaining deduction to reduce your net-long capital loss from Step 3. 

Step 5: Carry over any remaining net short-term or long-term capital loss after Step 4 to next year where it can be used to offset capital gains in 2023 and beyond.   

Overall gain for the year

If your gains in taxable accounts for the year exceed your losses, you have a net capital gain for the year. Congrats. Here’s the drill to figure out the tax results.

Step 1: Divide your gains and losses into short-term gains and losses from investments held for one year or less and long-term gains and losses from investments held for more than one year. 

Step 2: If your short-term gains exceed the total of your short-term and long-term losses, you have a net short-term capital gain for the year.

Step 3: If your long-term gains exceed the total of your long-term and short-term losses, you have a net long-term capital gain for the year.

Key point: You can potentially have both a net short-term capital gain and a net long-term loss capital gain.

Taxes on net short-term gain

If you have a net short-term capital gain, it will be taxed at your regular federal income tax rate, which can be as high as 37%. 

You may also owe the 3.8% net investment income tax (see below) and maybe state income tax too. 

Taxes on net long-term gain

If you have a net long-term capital gain (LTCG), it will be taxed at the lower federal capital gain tax rates which can be 0%, 15%, and 20%. Most folks will pay 15%. High-income folks will owe the maximum 20% rate on the lesser of: (1) your net LTCG or (2) the excess of your taxable income, including any net LTCG, over the applicable threshold. For 2022, the thresholds are $517,200 for married joint filers, $459,750 for single filers, and $488,500 for heads of households. 

You may also owe the 3.8% net investment income tax (see below) and maybe state income tax too.

Watch out for the wash sale rule

Our beloved Internal Revenue Code includes a nasty little trap for the unwary that’s called the wash sale rule. Under this rule, a tax loss from selling stock or mutual fund shares held in a taxable account is disallowed for federal income tax purposes if, within the 61-day period beginning 30 days before the date of the loss sale and ending 30 days after that date, you buy substantially identical securities. 

The theory is that the loss sale and the offsetting purchase of substantially identical securities within the 61-day period amount to an economic “wash.” Therefore, you’re not entitled to any tax loss, and the tax savings that would ordinarily result from the loss are disallowed.  

When you have a disallowed wash sale loss, the loss doesn’t vaporize. Instead, the general rule is that the disallowed loss is added to the tax basis of the substantially identical securities that triggered the wash sale rule. When you eventually sell those substantially identical securities, the extra basis reduces your tax gain or increases your tax loss. In effect, the disallowed wash sale loss becomes a deferred loss that’s taken into account when you sell the substantially identical securities. 

For details on the wash sale rule, see my earlier column..

Watch out for the 3.8% net investment income tax (NIIT)

Higher-income folks with net capital gains are exposed to the 3.8% net investment income tax (NIIT). The NIIT hits the lesser of your: (1) net investment income which includes capital gains and dividends or (2) the amount by which your modified adjusted gross income exceeds the applicable threshold. The threshold are as follows.

* $250,000 for married joint-filing couples.

* $200,000 if file as a single taxpayer or a head of household.

* $125,000 if you use married filing separate status. 

So, you could owe up to 40.8% to the Feds on a net short-term capital gain (37% + 3.8%). You could owe up to 23.8% (20% + 3.8%) on a net LTCG.

What about cryptocurrencies? 

Cryptocurrency transactions can potentially trigger taxable capital gains and tax-saving capital losses just like stock and mutual fund transactions. For details, see my earlier column

The bottom line: it’s a long time until yearend

As stated earlier, your tax results for 2022 are up in the air until all the gains and losses from trades executed during the year are tallied up. 

If you’ve got a net capital loss for the year so far, cheer up. Things could get better. I hope so.

If you’ve got a net capital gain for the year so far, don’t count your chickens yet. Things could get worse. I hope not. 

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