Common Investor Methods for Offsetting Ordinary Income

People who invest in stocks are expected to be rewarded with ordinary income and capital gains. Ordinary income is created from any dividends that are established from stocks or interest income from bonds. Investors who receive ordinary income find that it is taxed at the highest possible tax rate. For this reason many investors wish to offset ordinary income they receive by deductions allowed by the tax code so they can lower their tax bill.

Disadvantages of Ordinary Income

Investors receive ordinary income through the payment of dividends, or interest income. Investors have no say on when ordinary income is paid out by a company, or how much is paid out. On the other hand investors have complete control on whether they want to incur long term or short term capital gains which impacts the amount of tax they might have to pay. If an investor receives ordinary income from a stock or bond they own, they are taxed on this amount. The taxation rate for ordinary income is much higher when compared to capital gains. For this reason many investors try to minimize the tax bill by offsetting the gains with allowable tax deductions.

Capital Losses

If an investor has a large loss on a stock, they could possible use that loss to reduce their ordinary income. Normally a capital loss in a stock can be used to offset any capital gains. If the amount of capital losses exceed capital gains, up to $3,000 of the excess can be used to offset any ordinary income. This $3,000 limit is based on a married couple where each receives a limit of $1,500, or $3,000 for the couple.

Timing of Purchases

Stocks and bonds will announce when they plan on paying out a distribution. If you plan on purchasing, wait until after the distribution is made. If you purchase the day before the distribution, you will receive the distribution and be required to pay taxes on the amount. If you purchase after the distribution, then you an avoid payment of the tax.

Tax Efficient Funds

Every mutual fund has a ranking that shows the propensity of the tax bill that is generated from owning that mutual fund. It is possible to use this value to decide between the purchases of two mutual funds. An investor can come out ahead by potentially purchasing a mutual fund that offers a lower return and has a lower tax bill, when compared to a fund with a greater return and a higher tax bill. The higher tax bill reduces the higher return yielding a lower total return compared to the other fund.

Transferring the Tax Liability

If you own a stock or mutual fund that is expected to generate a large tax bill for ordinary income, you can donate the stock or mutual fund to a non-profit organization. By donating the stock, you avoid having to pay the tax bill on the ordinary income. Not every investor will be allowed to avoid the tax with donations so ask your tax preparer for more details.

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