How to Use Tax Lots to Pay Less Tax

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How to Use Tax Lots to Pay Less Tax

A succession of tax measures in recent years, culminating in the Tax Cuts and Jobs Act (TCJA) of 2017, have provided investors with a fantastic chance for long-term capital gains and dividend savings. However, in order to fully benefit from these improvements, you must utilize tax lots to manage your investment purchases and sells and report that revenue to the Internal Revenue Service (IRS).

For tax reasons, securities acquired in a single transaction are referred to as “a lot.” In other terms, a tax lot is a record of all transactions and their tax consequences involving a certain securities in a portfolio (dates of purchase and sale, cost basis, and selling price). Thinking in terms of tax lots may assist an investor make smart choices about which assets to sell and when, potentially saving thousands of dollars in taxes on those investments.

key takeaways

  • A tax lot is a record of all transactions and their tax consequences involving a certain securities in a portfolio (dates of acquisition and sale, cost basis, and selling price).
  • Thinking in terms of tax lots might assist an investor in making strategic choices on which assets to sell and when within a tax year.
  • Your choice of cost basis technique, in particular, may have a considerable influence on the calculation of capital gains and losses, as well as the taxes owing on such assets.

The Current Tax Rates

The current rates, enacted by the Tax Cuts and Jobs Act, are set to remain in effect until 2025. However, as of the publication date of this article, Congress has suggested substantial modifications that might raise these rates. Some tax hikes might be implemented retrospectively if the bill is enacted in its present form. It is critical to stay up to date on these initiatives for tax planning considerations. To get the most up-to-date information, go to the Tax Foundation’s website.

Long-term capital gains are taxed at 20% for single filers with income of $445,850 or more in 2021; married couples filing jointly pay $501,600. The rate is 15% for persons earning between $40,400 and $445,850 ($80,800 to $501,600 for couples), and 0% for those earning less than those amounts. The filer must have held the investment for at least one year in order to qualify for these rates.

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Short-term capital gains are subject to regular income taxation. The Act created seven income tax bands, with the lowest at 10% and the highest at 37%. Dividends, short-term capital gains, and long-term capital gains on stocks, bonds, and mutual funds are taxed differently based on your tax rate.

Stocks, Bonds, Mutual FundsTax Rate: Single Filers
Income $0-$40,400Income $40,401-$445,850Income
$445,851 and higher
Qualified Dividends0%15%20%
Short-Term Capital Gainsordinary tax bracketordinary tax bracketordinary tax bracket
Long-Term Capital Gains0%15%20%
Tax Rate: Married Filing Jointly
Income $0-$80,800Income $80,801-$501,600Income
$501,601 and higher
Qualified Dividends0%15%20%
Short-Term Capital Gainsordinary tax bracketordinary tax bracketordinary tax bracket
Long-Term Capital Gains0%15%20%

In addition to the rates shown in the table, higher-income earners may be subject to a 3.8% net investment income tax.

As the figure shows, short-term capital gains have the most unfavorable tax treatment and should be avoided in most circumstances. It is vital to remember that the lower dividend tax rate only applies to qualifying dividends. That is, unless the dividend is received on a security held for at least 60 days within the 121-day period commencing 60 days before the ex-dividend date, the lower rate does not apply.

How to Report Gains and Losses

For tax purposes, Form 1099-DIV separates ordinary and qualified dividends. You must maintain track of your initial cost basis on assets acquired in order to report short-term and long-term gains for the year on Schedule D-Capital Gains and Losses.

When calculating capital gains, short-term profits and losses are tallied first, followed by long-term gains and losses. You may then add the two results to obtain your total result. Avoid the wash-sale rule, which may invalidate a loss if you purchased shares of the same security within 30 days.

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Using Tax Lots to Your Advantage

When you sell shares, the cost basis technique you choose may have a substantial impact on the calculation of capital gains and losses. There are three popular methods for determining the cost basis of mutual fund shares that you are selling:

  • 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

The FIFO technique is popular since it is the default in most software programs and is useful for monitoring cost base. However, consider how the specific-shares technique might assist you in minimizing your profits when compared to the usual FIFO or LIFO systems. This is what it means to choose certain tax lots.

Assume you are in the 32% tax bracket and made the following purchases of XYZ stock over a two-year period.

Tax Lot #Cost Per ShareSharesPurchasedCurrent Price Per SharesGain
1$50800two years ago$75$25
2$58500nine months ago$75$17
3$70400six months ago$75$5

Assume you need to sell 800 shares of XYZ and want to reduce your tax liability:

Under the FIFO MethodTax ResultTaxes Due
Sell 800 shares of tax lot #1long-term gain of $20,000$3,000 ($20,000 x 15%)

User Specific-Shares MethodTax ResultTaxes Due
Sell 400 shares of tax lot #3short-term gain of $2,000$640 ($2,000 x 32%)
Sell 400 shares of tax lot #1long-term gain of $10,000$1,500 ($10,000 x 15%)

Total $2,140

Under the FIFO technique, you would sell the first 800 shares you acquired two years earlier, resulting in a $20,000 long-term gain and a $3,000 tax payment. If you opt to sell a particular tax lot instead, you may sell your most costly shares first, even if they were held for a short period of time, and still have a $2,140 tax charge.

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Strategies for Tax Minimization

Tracking stocks by tax lot is an excellent technique to reduce the amount of tax you owe on your earnings. Maintain in mind that you must keep proper records and always sell your most expensive holdings first.

Other ways to minimize taxes:

  • Short-term benefits should be avoided. This is an excellent general guideline to follow. However, it may make sense to sell a newer investment first if the capital gain is substantially smaller.
  • Avoid volatile funds and equities. They result in commissions, transaction expenses, and increased tax responsibilities. If you’re going to perform a lot of trading, be sure that every option is tax-wise worthwhile.
  • Make use of tax-advantaged funds. These mutual funds are designed to minimize tax liabilities. Their managers invest in the same equities as other funds, but they try to limit year-end capital gains distributions by doing less buying and selling inside the fund.
  • Get rid of your losers. Capture your losses and utilize them to balance your profits. Don’t be scared to incur losses that will carry over into future years.

The Bottom Line

There are many techniques for calculating your gain or loss on the selling of a securities. You must find and stick to the approach that works best for you. Although the first-in, first-out strategy is the simplest to compute and monitor, it is not necessarily the best.

If you choose the specific-shares technique, make sure you have written confirmation from your broker or custodian that your selling orders were received.

Investopedia does not provide tax, investment, or financial advice. The material is offered without regard for any individual investor’s investing goals, risk tolerance, or financial circumstances, and may not be appropriate for all investors. Investing entails risk, including the possibility of losing money. Investors should consult with a knowledgeable financial expert to develop an appropriate investment plan.

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