In general, when you make money, Uncle Sam wants a cut. Therefore, taxes are, for the most part, unavoidable. This means only to pay your fair share of taxes and nothing more. Understanding the mechanics of taxes is crucial in maximizing your money. This guide will break down capital gains and cover strategies to reduce taxes.
Before we get started, it’s important to note that capital gains apply to taxable investments. However, tax-advantaged accounts such as IRAs, 401k’s, and other workplace plans are insulated from capital gains.
When an asset is sold for more than it’s purchased for, it’s considered a realized capital gain. Taxes on capital gains will vary depending on your tax bracket and holding period, as discussed below.
There are exceptions beyond the extent of this guide, but capital gains apply to assets like mutual funds, ETFs, stocks, bonds, real estate, precious metals, property, and bitcoin.
When an asset is sold at a gain within one year of the purchase date, it realizes a short-term capital gain. Therefore, short-term gains are taxed at ordinary income rates. This is the same tax rate as salary and wages.
Here are the tax rates and brackets for the 2021 tax year:
Assets held for at least one year and one day are eligible for long-term capital gains. In addition, long-term gains receive a more favorable tax treatment than short-term gains.
Tax rates for long term capital gains are applied to the following taxable income brackets:
High earners might be subject to an additional 3.8% net investment income tax. In general, capital gains are subject to this extra tax. This means that instead of paying a 15% or 20% long-term capital gains tax, you could owe 18.8% or 23.8%.
This tax is based on your filing status and income. Therefore, you are likely subject to this tax if your modified adjusted gross income (MAGI) exceeds these income thresholds AND you have net investment income.
Fewer taxes paid mean more money in your pocket and less in Uncle Sam’s. This compounding effect on tax savings over many years can significantly increase overall wealth. While you cannot avoid taxes, there are a few strategies that could reduce taxes paid.
Harvesting losses is the process of strategically selling an investment at a loss to offset realized gains.
Let’s say you sell a fund and realize a $20,000 capital gain. You want to minimize taxes, so you sell another position that has a $10,000 loss. In this case, capital gain taxes are cut in half.
In addition, you can use losses in excess of gains to deduct on your tax return, up to $3,000 per year.
The mechanics of harvesting losses are as follows: Long-term losses are first matched up against long-term gains, then against short-term gains. Likewise, short-term losses are first matched up against short-term gains.
One thing to be aware of with tax loss harvesting is the wash sale rule. If you buy back the same or substantially identical security within 30 days of taking a loss, the loss will not be deductible.
This strategy is often overlooked. The opposite of tax-loss harvesting, gain harvesting is where you realize a capital gain in hopes of reducing taxes. Remember the long-term capital gains bracket above? You can potentially realize capital gains in a 0% bracket!
The purpose of this strategy is to pay 0% (sometimes even 15%) capital gain tax and then repurchase the stock, fund, or ETF to increase the basis. This can potentially result in fewer capital gains taxes in the future.
A perk with gain harvesting is there is no wash sale rule. Meaning you can sell stock or a fund at a gain, then repurchase it immediately.
Tax-advantaged accounts — 401k, 403b, IRA, Roth, SEP IRA, 457 — are not subject to capital gains tax. As a result, the investments can compound without the tax drag of capital gains and income. But, unfortunately, it also means you cannot deduct losses.
These accounts serve as a tax shelter to capital gains. It’s also wise to diversify the types of accounts that hold investments — taxable, pre-tax (traditional 401k, IRA), and tax-free (Roth).
Location isn’t just for real estate. When your investments are spread throughout different types of accounts — taxable, pre-tax, and Roth — the type of account you place the investment in can reduce taxes.
You can optimize asset location by placing investments that are tax-efficient inside taxable accounts. These are investments such as individual stocks held more than a year, ETFs, and tax-managed funds.
You can place tax-inefficient investments in tax-advantaged accounts. Tax inefficient investments include bonds, bond funds, mutual funds, and actively managed funds.
Rebalancing is bringing your investment mix back in line with your target allocation. Your target allocation is determined by your goals, risk tolerance, and time.
Instead of rebalancing each account with the same asset allocation, consider the allocation across all investment accounts. Looking through this lens, you can potentially make adjustments in tax-advantaged accounts to bring your total asset allocation back in line. Thus, minimizing the need to make adjustments in a taxable account and creating a tax liability.
Another idea, you can deploy new cash into investments that are underweight to bring your allocation back in line. Again, this is an easy way to rebalance without realizing capital gains.
The more you move investments in a taxable account, the more likely you’ll incur tax implications.
Long-term investors are often rewarded. By holding investments in a taxable account without selling, you can defer gains into the future. You will still pay taxes on income or dividends, but you can defer capital gains.
Another advantage to this is the future benefit of tax harvesting or step-up in basis to beneficiaries.
Saving money on taxes can increase overall returns and contribute to future wealth. However, with any tax planning strategy, taxes shouldn’t be the primary driver of financial decisions. Instead, do what’s best for your situation and needs first, then optimize the tax component.
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