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How to Save Money on Taxes by Using Tax Lots

How to Save Money on Taxes by Using Tax Lots

In recent years, a series of tax measures, culminating in the Tax Cuts and Jobs Act (TCJA) of 2017, have provided investors with significant tax reductions on long-term capital gains and dividends. However, using tax lots to manage your investment purchases and sales, and reporting that income to the Internal Revenue Service, is the best method to take full benefit of these improvements (IRS).

For tax purposes, securities purchased in a single transaction are referred to as “a lot.” In other words, a tax lot is a record of all transactions involving specific securities in a portfolio, as well as their tax implications (dates of acquisition and sale, cost basis, and sale price). Thinking in terms of tax lots can assist an investor in making smart decisions about which assets to sell and when resulting in significant reductions in the amount of tax owed on such investments.

Tax Rates Currently in Effect

The present rates, which were enacted as part of the Tax Cuts and Jobs Act, are set to last until 2025.

For single taxpayers with an income of $445,850 or more in 2021, the long-term capital gains tax rate is 20%; for married couples filing jointly, it is $501,600. For persons earning between $40,400 and $445,850 ($80,800 to $501,600 for couples), the tax decreases to 15%, and for those earning less than those amounts, the rate is 0%. The filer must have owned the investment for at least one year to qualify for these rates.

Short-term capital gains are taxed at the same rate as regular income. The Act introduced seven income tax rates, ranging from 10% for low-income workers to 37% for the wealthiest 1% of the population. 5 Dividends, short-term capital gains, and long-term capital gains on stocks, bonds, and mutual funds are all taxed differently based on your tax rate.

How to Calculate and Report Gains and Losses

For tax purposes, Form 1099-DIV separates ordinary and qualified dividends. To record short-term and long-term gains for the year on the Schedule D-Capital Gains and Losses form, you must maintain track of your original cost basis on securities that you purchased.

Short-term profits and losses are totaled first, followed by long-term gains and losses for calculating capital gains. After that, you can add the two results together to get the final result. Avoid the wash-sale rule, which prevents you from claiming a loss if you buy shares of the same security within 30 days.

Taking Advantage of Tax Lots

When you sell shares, the cost basis technique you use can have a big impact on how you calculate 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 method of the average cost

The method of specific-share

You can use the following formulas to calculate specific stocks and bonds:

  • LIFO (last in, first out)

The method of specific-shares

The FIFO approach is most commonly used because it is the default in most software programs and it is easy to track cost basis. However, consider how the specific-shares strategy can assist you to reduce your gains when compared to other methods.

Minimization of Taxes Strategies

Tracking stocks by tax lot is a wonderful technique to reduce the amount of money you have to pay in taxes. Keep in mind that it necessitates meticulous record-keeping and the sale of your highest-cost positions initially.

Other strategies to save money on taxes include:

Short-term benefits should be avoided. This is an excellent rule of thumb to follow. However, if selling a newer position first results in a considerably lower capital gain, it may make sense.

Avoid funds and stocks with a high turnover rate. They result in commissions, transaction expenses, and increased tax obligations. If you plan on doing a lot of trading, make sure that every option is tax-wise worthwhile.

Make use of monies that are administered by the government. These mutual funds are set up to help you save money on taxes. Their managers invest in the same equities as other funds but try to keep year-end capital gains distributions to a minimum by doing less buying and selling within the fund.

Your losers should be sold. Take advantage of your losses and use them to balance out your wins. Don’t be scared to make losses that will carry over to subsequent years.

Conclusion

There are several methods for calculating your gain or loss on a security sale. You must choose the strategy that is most effective for you and stick to it. Although the first-in, first-out strategy is the most straightforward to compute and track, it is not always the best option.

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

The Author

Oladotun Olayemi

Dotun is a financial enthusiast who specializes in first-in-class financial content, including crypto, blockchain, market, and business, to educate and inform readers.