With the end of the year approaching, we thought it was a good time to review some simple tips for individual investors that can help you lower your tax bill.
- First, the basics. 
- What are some strategies for reducing the tax bill? 
- What if you sell something at a loss and rebuy it later? 
- Can capital losses be used to offset other income? 
- Let’s do a simple example. 
- Is there a right time to sell for tax purposes? 
- What tax incentives come with other types of securities? 
- Conclusion 
First, the basics.
If you earn money on a stock you sell, that is called a gain or capital gain. If you have owned the stock for one year or less, it is a short-term gain. Longer than a year, it’s a long-term gain.
Short-term gains are generally taxed at a higher rate than long-term gains—they are taxed at your regular tax rate rather than at the long-term rate of 15%, or 20% for high earners.
When you lose money on a stock you sell, that is a loss or capital loss. As with gains, you have short-term losses and long-term losses.
What are some strategies for reducing the tax bill?
Because of the lower tax rate on long-term capital gains, aim for holding periods of longer than a year, so that gains can be taxed at a lower rate. However, obviously that is just one consideration of many. If you have a good reason to sell a stock before a year is up, then you should do so.
If you have taxable gains, it’s a good idea to look for losers to offset the gains. This is called tax loss harvesting. If you still like the losers, consider selling them and buying something roughly equivalent (e.g., selling GM and buying Ford).
It’s important to remember that short-term losses offset short-term gains first, then they can be used toward long-term gains. And long-term losses can only offset long-term gains; they cannot offset short-term gains. Long-term losses can be rolled into the following year, while short-term and long-term gains are not rolled into future years. So it’s helpful to know what kinds of gains you have to figure out what kinds of losses you want to take.
If you have a short-term gain, you can only offset it with a short-term loss. If you have a long-term gain, then you can use either short- or long-term losses to offset—although when in doubt, taking a long-term loss is safer in this situation, if only to free up short-term losses for any short-term gains you may have. Of course, once again, the decision will also depend on what stocks you actually care to sell.
What if you sell something at a loss and rebuy it later?
There is something called the 30-day wash-sale  rule, which says that if you sell something for a loss and you rebuy it (or something substantially identical, such as an option on the stock) within 30 days, the loss is disallowed. However, the loss is rolled into basis on new shares, so it is not lost forever.
The rule is designed to prevent investors from creating artificial losses in order to lower their tax bill. To avoid a wash sale, you can look into buying similar stocks or industry ETFs rather than re-buying shares of a stock you recently sold.
Can capital losses be used to offset other income?
Yes, to a limited extent. You can use $3,000 of any leftover long-term capital loss per year as a deduction against earned income , such as income from your job. If you have a long-term loss that rolls over multiple years, you can take $3,000 of it each year as a deduction against earned income. Remember, long-term gains come first, then whatever remains of your long-term losses can be used against earned income (up to $3,000 per year).
Let’s do a simple example.
If you have $10,000 in short-term gains and $20,000 in long-term losses, you will pay taxes on all of the short-term gains, at your normal tax rate, and roll the long-term losses forward for future use (less $3,000 used to offset earned income). You can apply the remaining $17,000 of long-term losses to offset long-term gains in the future, until it runs out. If you have no or low long-term capital gains, you can still use $3,000 of the loss each year (until it runs out) as a deduction against earned income.
Is there a right time to sell for tax purposes?
Anytime works, but late December is especially fruitful as you will know exactly where you stand with gainers, losers and the tax bill.
What tax incentives come with other types of securities?
There are several different instruments that can help you keep your tax rate low, including:
- Tax-free municipal bonds. If you buy them in the state in which you live, they are also exempt of state tax.
- Tax-free bond funds (which hold individual municipal bonds). You can even get tax-free bond funds that own only, say, Massachusetts or California bonds.
- Tax-free closed end funds (CEFs). These are trickier as they can sell at a discount or premium to net asset value (NAV). They also often use leverage, which can enhance returns, but make them more risky, especially when things go south.
- MLPs. These are complex and offer pros and cons from a tax perspective. They are generally confined to the energy infrastructure space (pipelines, terminal storage etc.). With MLPs, you are a limited partner and get a K1 (separate tax form) and must also pay taxes in the states that the MLP operate in. You will probably need an accountant to do your taxes if you go the MLP route. The benefits are that almost all free cash flow from MLPs are paid out in dividends (called distributions). These distributions are considered a return of capital, which isn’t taxed at all, but does lower your basis. So if you sell, then you will book a bigger gain (or smaller loss) as your basis is lower. If you never sell and then you die, there is a step up, so your heirs get the stock at current value with a stepped up basis. It’s a great loophole if you don’t mind dying to achieve it. For more on MLPs, check out this article .
That’s all for now. We hope this was a useful introduction to some of the basic strategies individual investors can employ to reduce their tax burden. May your gains outweigh your losses—but now you know how to put your losses to good use!