When it comes to taxing investments, not all shares are created equal
A series of tax bills in recent years, culminating in the Tax Cuts and Jobs Act (TCJA) of 2017, has given investors a tremendous opportunity for savings on long-term capital gains and dividends. But the way to take full advantage of these changes is to use tax lots in managing your investment purchases and sales, and reporting that income to the Internal Revenue Service (IRS).
Securities purchased in a single transaction are referred to as “a lot” for tax purposes.1 In other words, a tax lot is a record of all transactions and their tax implications (dates of purchase and sale, cost basis, sale price) involving a particular security in a portfolio. Thinking in terms of tax lots can help an investor make strategic decisions about which assets to sell and when, making a big difference in the taxes owed on those investments.
KEY TAKEAWAYS
- A tax lot is a record of all transactions and their tax implications (dates of purchase and sale, cost basis, sale price) involving a particular security in a portfolio.
- Thinking in terms of tax lots can help an investor make strategic decisions about which assets to sell and when in a tax year.
- In particular, your choice of cost basis method can have a significant effect on the computation of capital gains and losses and significantly impact the taxes owed on those investments.
The Current Tax Rates
The current rates, instituted by the Tax Cuts and Jobs Act, are intended to stay in place through 2025.2 However, as of the date of this article, there are significant changes being proposed by Congress that could increase these rates. If passed in its current form, some tax increases could be made retroactively. It’s important to keep abreast of these proposals for tax planning purposes. You can visit the Tax Foundation website to access the latest information.
The tax rate on long-term capital gains tops out at 20% for single filers who report over $492,300 or more in income in 2023; for married folks filing jointly, it’s $553,850. The rate drops to 15% for those who make between $44,625 and $492,300 ($89,250 to $553,850 for couples) and it’s 0% for those whose income is under those respective minimums. To get these rates, the filer must have owned the investment for at least one year.34
Short-term capital gains are taxed as ordinary income. The Act established seven income tax brackets ranging from 10% for low-income earners to 37% for top earners.5 Below is a quick look at how your dividends, short-term capital gains, and long-term capital gains will be taxed on your stocks, bonds, and mutual funds, depending on your tax bracket.6
| Stocks, Bonds, Mutual Funds | Tax Rate: Single Filers | ||
|---|---|---|---|
| Income $0-$44,625 | Income $44,626-$492,300 | Income $492,301 and higher | |
| Qualified Dividends | 0% | 15% | 20% |
| Short-Term Capital Gains | ordinary tax bracket | ordinary tax bracket | ordinary tax bracket |
| Long-Term Capital Gains | 0% | 15% | 20% |
| Tax Rate: Married Filing Jointly | |||
| Income $0-$89,250 | Income $89,251-$553,850 | Income $553,851 and higher | |
| Qualified Dividends | 0% | 15% | 20% |
| Short-Term Capital Gains | ordinary tax bracket | ordinary tax bracket | ordinary tax bracket |
| Long-Term Capital Gains | 0% | 15% | 20% |
In addition to the rates listed in the table, higher-income taxpayers may also have to pay an additional 3.8% net investment income tax.7
As you can see from the chart, short-term capital gains receive the least-favorable tax treatment and should be avoided in most cases. It is important to note that the reduced tax rate for dividends applies only to qualified dividends. That is, the reduced rate does not apply unless the dividend is received on a security held for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date.8
How to Report Gains and Losses
Form 1099-DIV breaks down ordinary and qualified dividends for you for tax purposes. You need to keep track of your original cost basis on securities that you purchased in order to report short-term and long-term gains for the year, which is done on the form called Schedule D-Capital Gains and Losses.9
When computing your capital gains, the short-term gains and losses are first netted, and then long-term gains and losses are netted. You can then net the two results together to compute your overall result. Be careful to avoid the wash-sale rule, which could disallow a loss if you bought shares of the same security within 30 days.10
Using Tax Lots to Your Advantage
Your choice of cost basis method can have a significant effect on the computation of capital gains and losses when you sell shares.1 For mutual fund shares, there are three common ways to identify the cost basis of the shares that you are selling:11
- FIFO (first-in, first-out)
- The average-cost method
- The specific-share method
For individual stocks and bonds, you can use:
- FIFO
- LIFO (last in, first out)
- The specific-shares method
Most people choose the FIFO method because it is the default in most software packages, and it’s convenient for tracking cost basis. But take a look at how the specific-shares method can help you minimize your gains compared to those standard FIFO or LIFO methods. This is what is meant by selecting specific tax lots.
Suppose, for example, that you are in the 32% tax bracket and you made the following purchases of XYZ stock over a two-year period.
| Tax Lot # | Cost Per Share | Shares | Purchased | Current Price Per Shares | Gain |
|---|---|---|---|---|---|
| 1 | $50 | 800 | two years ago | $75 | $25 |
| 2 | $58 | 500 | nine months ago | $75 | $17 |
| 3 | $70 | 400 | six months ago | $75 | $5 |
Now, suppose that you need to sell 800 shares of XYZ and you want to minimize your tax consequence:
| Under the FIFO Method | Tax Result | Taxes Due |
|---|---|---|
| Sell 800 shares of tax lot #1 | long-term gain of $20,000 | $3,000 ($20,000 x 15%) |
| User Specific-Shares Method | Tax Result | Taxes Due |
|---|---|---|
| Sell 400 shares of tax lot #3 | short-term gain of $2,000 | $640 ($2,000 x 32%) |
| Sell 400 shares of tax lot #1 | long-term gain of $10,000 | $1,500 ($10,000 x 15%) |
Total $2,140
Under the FIFO method, you would sell the first 800 shares that you purchased two years ago, resulting in a long-term gain of $20,000, with a tax bill of $3,000. If you choose to sell a specific tax lot instead, you can sell your most expensive shares first, even though they were held short-term, and still have a lower tax bill of $2,140.
Strategies for Tax Minimization
Tracking securities by tax lot is a great way to minimize the taxes you owe on your gains. Keep in mind that it requires you to keep accurate records and always sell your highest-cost positions first.
Other ways to minimize taxes:
- Avoid short-term gains. This is a good general rule of thumb. That said, it occasionally makes sense to sell a newer position first, if it means a much lower capital gain.
- Avoid high-turnover funds and stocks. They generate commissions, transaction costs, and higher tax liabilities. If you’re going to do a lot of trading, make sure that every decision is worth it from a tax perspective.
- Use tax-managed funds. These mutual funds are structured to reduce tax liability. Their managers invest in the same stocks as other funds, but seek to minimize the year-end distributions of capital gains by less buying and selling within the fund.
- Sell your losers. Harvest your losses and use them to offset gains. Don’t be afraid to generate losses that carry forward for future years.
The Bottom Line
There are a number of methods of determining your gain or loss on the sale of a security. You must determine the method that works best for you and stick with it. Although the first-in, first-out method might be the easiest to calculate and track, it might not always be the most advantageous.
If you do take advantage of the specific-shares method, make sure you receive a written confirmation from your broker or custodian acknowledging your selling instructions.
