In another post, I’ve written about using capital losses to offset capital gains to help manage your income tax bill. But, to a limited extent, you can deduct capital losses from ordinary income. This can be useful if your ordinary income tax rate is higher than your capital gains tax rate.
Here’s an example. Let’s say you earn $350,000 per year and your marginal income tax rate is 35% and your long-term capital gains tax rate is 15%. If you realize a capital loss, you can deduct up to $3,000 of that loss against your ordinary income. At 35%, that means you can save $1,050 in income taxes by realizing the loss and deducting it against your ordinary income.
Alternatively, you could use the capital loss to offset a capital gain. But that gain (if it’s a long-term capital gain) is only taxed at 15%. So if you use a $3,000 loss to offset a $3,000 long-term gain, you save only 15% of $3,000, or just $450.
I have two key opinions to offer on this.
First, I think taxes are the tail and not the dog. Buying and selling investments should be about big picture financial goals, not about taxes. So I don’t buy and sell mutual funds or ETFs just for tax reasons. But if achieving my financial goals also helps me to save on taxes, then I am all for it.
Second, if I do sell losing investments and get an income tax deduction by doing so, I also try to make sure that I maintain my overall target asset allocation. By staying focused on my target allocation–again–I don’t let income tax considerations rule my investment decisions. But if I can deduct capital losses from ordinary income, I certainly do!
