When it comes to investing, one thing investors can’t avoid is paying capital gains taxes on their profits. While taxes are an unavoidable part of investing, there are smart strategies you can employ in seeking to reduce your tax bill and keep more of your profits. By understanding how capital gains taxes work and implementing tax-efficient investment strategies, you can strengthen your financial portfolio and keep your investments on track. Let’s explore some of these tips and tricks for potentially reducing your capital gains tax so you place more of your hard-earned money back into your pocket.
1. Wait a Little Longer to Sell
Timing the sale of your investments is critical to lowering your capital gains taxes. Selling your shares after holding for less than a year will result in a short-term capital gains tax. This means that all the gains you made from the sale of the stock will be taxed at your ordinary income rate, (1) which can be 32%-37% for high-earners. Holding on to an asset for more than one year will be taxed at the long-term capital gains tax rate, (2) which can be 0%, 15%, or 20%.
Holding periods are also critical when it comes to the sale of real estate. If you sell your primary home and you lived in the home for at least two years of the five-year period before the sale, the IRS allows you to exclude the first $250,000 of capital gains (3) (or $500,000 for a married couple filing jointly). While the capital gains exclusions do not apply to investment properties, you may be able to utilize like-kind exchanges to defer capital gains tax by reinvesting in other real estate.
2. Utilize Tax-Loss Harvesting (TLH)
Losing money on your investments is usually a bad thing, but utilizing a tax-loss harvesting strategy means you can claim capital losses to offset your capital gains. If you show a net capital loss, you can use the loss to reduce your ordinary income by up to $3,000 (or $1,500 if you are married and filing separately). Losses above the IRS limit (4) can be carried over to future years. Sometimes it is advantageous to sell depreciated assets for this reason. A tax-loss harvesting strategy can help minimize your tax liability and keep more money in your pocket. However, trying to reduce taxes shouldn’t come at the expense of maintaining a thoughtful asset allocation in your portfolio.
3. Asset Location
Some investments will be more tax-efficient than others. For example, a municipal bond is considered the most tax-efficient security because income from municipal bonds are federally tax-exempt and may be state tax-exempt. Investments like high-yield bonds are considered less tax-efficient because payments are not tax-exempt, meaning they are taxed as ordinary income. When looking at the table below, (5) assets at the top are more tax-efficient than assets at the bottom.
Like assets, there are investment accounts that are more tax-friendly. Tax-advantaged accounts allow you to defer paying taxes on the gains or earnings to a later date. For example, a traditional IRA or a 401(k) will allow you to contribute using pre-tax income and withdrawals are taxed when you retire, when your income is typically lower.
Pairing tax-advantaged accounts like a 401(k) with tax-inefficient assets like a high-yield bond and pairing taxable accounts (individual, joint, trust, etc.) with more tax-efficient assets will create a more optimal mix to minimize tax liability. Placing investments that have higher tax rates with accounts that delay taxes will help reduce the amount you owe. Since you are not expected to pay federal taxes on something like income from a municipal bond, there is no use placing it in a tax-advantaged account because there are no taxes to delay.
Of course, this is a bit of an oversimplification as there are many nuances that can make certain investment vehicles more tax-efficient than others. For example, although REITs are toward the bottom of the table, there are still plenty of advantages to investing in them. Dividends from REITs are sheltered from corporate tax, and some dividends are considered a return of capital that isn’t taxed at all. This is why it is imperative to work with an experienced professional who can use the nuances of each financial instrument to your advantage.
4. Understand Cost Basis & Share Lots
When you buy any amount of stock, the stock is assigned a lot number regardless of the number of shares. If you have made multiple purchases of the same stock, each purchase is assigned to a different lot number with a different cost basis (determined by the price at the time of each purchase). Consequently, each lot will have appreciated or depreciated in different amounts. Some brokerage accounts use first in, first out (FIFO) by default. If you utilize FIFO, your oldest lots will be sold first. Sometimes FIFO makes sense, but not always. Sometimes it is ideal to sell lots with the highest cost basis, which is commonly done as part of a tax-loss harvesting strategy.
Passing on assets as an inheritance can also increase your cost basis. Assets passed on to the next generation at the time of death allow your heirs to pay tax only on capital gains that occur after they inherit your property, through a one-time “step up in basis.” (6) For example, when one spouse dies, assets passed on to the surviving spouse will have a cost basis of the price of the asset on the day in which they passed. This eliminates the deceased spouse’s portion of capital gains.
We’re Here to Support Your Financial Journey
Although no one likes paying taxes, paying capital gains taxes can actually be a positive sign that your financial strategies are performing well. While reducing your capital gains taxes can support your overall financial strategy, it’s just one piece of the puzzle when it comes to pursuing your investment goals.
If you’re interested in implementing a holistic approach that takes into account a wide range of factors, working with a financial professional can help you create a comprehensive plan tailored to your unique needs and goals. To learn more, schedule a no-obligation, get-acquainted meeting, or call us at 207-504-3614.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free, but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF's net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.
Investing in Real Estate Investment Trusts (REITs) involves special risks, such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained.
Stock investing includes risks, including fluctuating prices and loss of principal.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Jody James is an LPL financial advisor at James Financial Group, a firm that takes the mystery out of investing, managing risk, and preparing for retirement. With over 10 years of experience in the wealth management industry, Jody works closely with individuals and small business owners to craft creative and customized strategies that allow them to work toward their financial and life goals and preserving their wealth. Serving as a bridge between Wall Street and Main Street, Jody loves the juxtaposition and synergy as he helps clients pursue their dreams while also making an impact on the local community—raising capital for other businesses, entrepreneurs, and innovators.
Jody has a bachelor’s degree in history from Le Moyne College, an MBA from Brandeis University, and holds the Series 7 and Series 66 registrations with LPL Financial. When he’s not working, he enjoys traveling, working out, and spending time with his wife and three children, whom he adores. He’s also a huge New England Patriots fan. To learn more about Jody, connect with him on LinkedIn.