Income tax expense is the largest expense you’ll encounter in your life, bigger than your mortgage or the cost of getting through college. There is however, a way to offset your tax expense with your capital losses.
It could be to your financial advantage to finally sell the stock that will most likely never recoup and turn that investing disappointment around by claiming the loss against any capital gains you might have for the tax year. You will end up not paying any tax on your positive returns on investment. Most taxpayers will be taxed at a 15% rate on long-term capital gains. More affluent taxpayers will be taxed at a 20% rate. Therefore, you’re saving by not paying the IRS and it’s totally legal.
If you don’t have any capital gains, you can deduct up to $3,000 of your capital losses against ordinary income for the tax year. Ordinary income is defined as income received that is taxed at the highest rates and is composed mainly of wages, salaries, commissions and interest income. Any excess can be carried forward indefinitely for use in reducing your taxable income in upcoming tax years.
This could be a deal breaker for some when it comes to staying or dropping out of the stock market. If an individual makes calculated decisions and shows capital gains in the future, they will recoup their capital losses faster than if they would just rely on ordinary income to replace the money they’ve lost.
Rules for corporations looking to catch a tax break on their capital losses differ from rules that apply to individuals.
First of all, capital gains are not taxed at lower, preferential rates for corporations. Even though individual taxpayers pay less tax on their capital gains than on ordinary income, corporations pay the same amount. Furthermore, both corporations and individuals can deduct the capital losses against capital gains they’ve received during the tax year but corporate taxpayers cannot deduct their capital losses against their ordinary income. They can carry the excess capital loss back three years and forward five years. After five years, the corporation will not be able to take advantage of the tax savings. So, if the tax payer does not completely use up the capital loss by the end of the carry-forward period, it will be lost forever. Also, the carry-back of a loss must not increase or result in a net operating loss for the year to which it is being carried back. In that case, it must only be carried forward.
All in all, do not be quick to exit the stock market if you had a bad year. Sometimes stock losses can be turned into tax savings.