When investing in non-qualified accounts—those outside of tax-advantaged retirement accounts like IRAs, Roth IRAs, and 401(k)s—understanding capital gains and losses is essential for effective tax planning. Non-qualified investments may generate capital gains and capital losses that impact your taxes differently from traditional income. Here, we’ll break down the basics of capital gains and losses, explore valuable strategies like tax-loss harvesting and capital loss carry-forwards, and discuss the “step-up in basis” that can provide significant tax benefits to heirs.

What Are Capital Gains and Losses?

Capital Gains

• A capital gain occurs when you sell an asset—such as stocks, bonds, or real estate—for more than its purchase price. These gains are taxable, but the rate you pay depends on how long you held the asset:
  • Short-Term Capital Gains: If you held the asset for one year or less, the gain is considered short-term and is taxed as ordinary income. This can lead to a higher tax rate, depending on your income bracket.
  • Long-Term Capital Gains: If you held the asset for more than one year, the gain is taxed at the long-term capital gains rate, which is more favorable than ordinary income tax rates. The long-term capital gains rates are 0%, 15%, or 20%, based on your taxable income. For those in the lower tax brackets, long-term capital gains may even be taxed at 0%, providing substantial tax savings compared to ordinary income rates.

Capital Losses

• A capital loss occurs when you sell an asset for less than its purchase price. While losses aren’t ideal, they can offer tax benefits by offsetting capital gains and potentially reducing your taxable income. Losses from non-qualified accounts can be used in several ways:
  • Offset Capital Gains: Capital losses offset capital gains dollar-for-dollar, reducing the total amount of taxable gains.
  • Reduce Ordinary Income: If your losses exceed your gains, you can use up to $3,000 ($1,500 if married filing separately) of these losses each year to offset ordinary income, potentially lowering your overall tax bill.
  • Carry Forward Excess Losses: If your losses exceed both capital gains and the $3,000 limit for offsetting ordinary income, you can carry forward the remaining losses to future years, which we’ll explore in detail below.

It’s important to remember that these tax implications only apply to non-qualified accounts. In tax-advantaged accounts like IRAs, Roth IRAs, and 401(k)s, capital gains and losses don’t apply.

Tax-Loss Harvesting: Turning Losses into Tax Savings

Tax-loss harvesting is a strategy in non-qualified accounts where you sell investments at a loss to offset gains from other investments or reduce ordinary income. This can be a powerful way to manage your tax liability, especially during years when your investments generate significant gains.

• How It Works: By realizing a loss, you can use it to offset gains from other assets in your portfolio. For example, if you realized $10,000 in capital gains but also had $4,000 in losses, your net taxable gain would be reduced to $6,000.
• Wash-Sale Rule: To prevent investors from selling a losing asset just to claim a tax deduction and then immediately repurchasing it, the IRS enforces the wash-sale rule. This rule states that if you buy back the same or a “substantially identical” asset within 30 days, you cannot claim the loss for tax purposes. To comply, you may reinvest in a different but similar investment to maintain your portfolio’s desired exposure.

Capital Loss Carry-Forwards: Extending Tax Benefits Over Time

If your capital losses exceed your capital gains in a given year, you can carry forward those unused losses to future tax years. Known as a capital loss carry-forward, this allows you to continue reducing taxable income even in years when your losses exceed gains.

• Offset Future Gains: Any unused losses can be carried forward to offset gains in future years. This provides flexibility to manage taxes strategically over time.
• Offset Ordinary Income: Each year, you can apply up to $3,000 of remaining losses to reduce ordinary income, creating additional tax-saving opportunities year after year.

Capital loss carry-forwards can be a highly effective tool, particularly for investors who anticipate higher capital gains in future years or want a tax-efficient strategy for managing long-term gains.

The Step-Up in Basis: A Tax Benefit for Heirs

Another important concept for non-qualified accounts is the step-up in basis upon inheritance. When an individual passes away, the cost basis of their assets in non-qualified accounts is “stepped up” to the current market value at the time of their death. This step-up can offer substantial tax advantages for heirs:

• How It Works: If an asset’s value has increased over time, the step-up in basis means that the cost basis is adjusted to the asset’s value on the date of the original owner’s death. If the heir later sells the asset, they only pay taxes on the increase in value from the date of inheritance—not from the original purchase date.
• Example: Let’s say an individual bought stock for $50,000, and it’s worth $200,000 at the time of their death. With the step-up in basis, the heir’s new cost basis is $200,000. If the heir sells the stock for $210,000, they only owe capital gains tax on $10,000 (the difference between $200,000 and $210,000), rather than $160,000 (the difference between $50,000 and $210,000).

This step-up in basis can greatly reduce the tax burden on inherited assets, allowing heirs to retain more of the inherited wealth.

Why These Strategies Don’t Apply to Qualified Accounts

It’s essential to remember that capital gains, losses, and the step-up in basis only apply to assets held in non-qualified accounts. In tax-advantaged accounts like IRAs, Roth IRAs, and 401(k)s, these tax rules don’t apply:

• Traditional IRAs and 401(k)s: Contributions are often tax-deductible, and investments grow tax-deferred. When you withdraw funds in retirement, they’re taxed as ordinary income, regardless of how long you held the investments or whether they appreciated.
• Roth IRAs: Contributions are made with after-tax dollars, and qualified withdrawals are tax-free. The growth within a Roth IRA is not taxed, and capital gains or losses do not apply.

These accounts are powerful tools for retirement savings, but the tax rules are different from non-qualified accounts. For investors with both types of accounts, understanding these differences can help create a tax-smart approach.

Making the Most of Capital Gains, Losses, and the Step-Up in Basis

Effectively managing capital gains and losses in non-qualified accounts can improve after-tax returns and preserve wealth for the future. Strategies like tax-loss harvesting and capital loss carry-forwards help you reduce taxes during your lifetime, while the step-up in basis can provide a valuable tax benefit to your heirs.

At Jackson Wealth Management, we help clients integrate these strategies into their overall financial plan. By collaborating with tax professionals, we can tailor a plan to your unique needs, helping to ensure that you maximize the benefits of tax-efficient investing.

Do you have questions about managing capital gains, losses, or planning for tax efficiency in your investment portfolio? Click here to reach out and let us help you build a tax-smart strategy for your financial future.