There are several ways your investments create taxable income—including interest, dividends, and capital gains.
The profits you make from selling your stocks can be a huge factor in your capital gains taxes and income tax.
Making money is great. but understanding how to reduce capital gains tax on stocks will be an important step to keeping your wealth.
A financial advisor with capital gains tax expertise may be able to help you create a plan to navigate capital gains taxes on your portfolio.
Many investors seek to control their capital gains liabilities so as not to increase their tax burden.
Today, we’ll evaluate a few strategies that may help you avoid paying heavy rates when selling your stocks, and filing your tax return.
Here‘s how to reduce capital gains tax on stocks. If you want to know how the capital gains tax is calculated, go here.
Control Your Asset Location
To start, let's give a quick refresh on capital gains tax.
Capital gains tax is a specific type of federal tax incurred on the sale of the investment. There are two types:
Short-term capital gains tax
Long-term capital gains tax
If you hold an investment for less than a year, your investments will be taxed at short-term capital gains rates, which end up being the same as ordinary income tax rates.
But holding assets can come with significant tax benefits. By holding an asset for a year or more, you qualify for long-term capital gains tax rates, which are much more favorable (and often lower rates), either 0%, 15%, or 20% depending on your income for the year.
Now, let's begin to look at how taxpayers can mitigate them.
The first and most critical part of mitigating capital gains (and ordinary income) tax is to ensure your assets are in the right accounts.
This strategy is known as asset location or putting different securities in the most tax-efficient accounts for that particular investment.
Tax-advantaged accounts, both pre-tax and Roth, like 401(k)s, IRAs, HSAs, and other retirement accounts, are powerful tools for shielding your investments from capital gains taxes and lowering your taxable income— but you don't want your entire portfolio squirreled away within them.
Given that each type of tax-advantaged account has contribution limits, you may not be able to put your entire savings into them anyway.
Whatever the case, you’ll likely hold some of your investments in a taxable brokerage account. With your savings split between taxable and tax-advantaged accounts, you should be mindful of which assets are in each account type.
Where Should You House Your Securities?
So, where should you start?
You’ll want to evaluate the tax efficiency of your investments.
A good rule of thumb is to use tax-advantaged accounts for more actively traded positions or less tax-efficient investments and direct your more tax-efficient and non-U.S. investments into taxable brokerage accounts.
Best Practice 1: Keep High Return Investments In Tax-Exempt Accounts
You should generally hold investments with the highest expected returns in Roth IRAs and HSAs. That’s because you can withdraw money from these accounts tax-free, so all that growth won’t drive up your tax bill in future years.
Best Practice 2: Investments With Short-Term Capital Gains Are Often Best In Tax-Deferred Accounts
If you hold active mutual funds, bonds, or engage in active stock trading, it’s often best to keep these investments in tax-deferred accounts like traditional IRAs.
Why?
These investments are more likely to create short-term capital gains that are taxed as income. Since distributions from tax-deferred accounts are taxed as income anyway, you aren’t really giving anything up, but you won’t be taxed along the way.
Best Practice 3: Stable, Tax-Efficient Investments Work Well In Taxable Accounts
And lastly, try to hold your most tax-efficient investments in your taxable brokerage account.
Index stock funds and stocks that you do not plan to trade frequently are great examples.
Taxable brokerage accounts have a distinct advantage: shares receive a step up on the cost basis when you pass, meaning the gain will be reduced, and your heirs will keep more of their value. As a result, you may be able to transfer more after-tax money to your heirs.
Consider Donating Appreciated Stock
If you have significantly appreciated stock since the time you purchased it, you have a potential tax liability when you ultimately sell those shares.
However, did you know that filers can avoid that capital gain tax altogether?
If you donate appreciated stock to a qualified charity, you are not subject to capital gains tax on those shares.
This idea can be beneficial if you regularly donate to charities. Donating appreciated stock benefits the charity since they don’t have any tax liability on the gift, and it can help you allay a future tax burden. In this case, the charity now owns an asset that has the potential to increase in value, making your gift worth even more.
You can also consider this option in conjunction with a portfolio rebalance. If you donate appreciated shares, you reduce your holding of that asset class, and then you can use the cash to purchase underweighted investments to bring your portfolio back in balance.
You could even donate the shares to a donor-advised fund (DAF) to receive the same benefit. Then, you can direct payments from the DAF to a qualified charity at a later date.
Donating stock can be a great avenue to itemize deductions. Given the massive increase to the standard deduction via the Tax Cuts and Jobs Act, you may need to pick and choose years where you want to itemize, and donating could be a great way to get there!
Use Tax-Loss Harvesting
You can calculate your capital gains tax in three simple steps:
Determine your cost basis (the price you paid including fees)
Calculate your realized amount (price you paid minus sale price)
Subtract your cost basis from your realized amount
While you may always want your stocks to earn money, sometimes it makes sense to sell a stock at a loss to reduce your net capital gain for the year. If you made significant gains in one stock, you can sell another at a loss and reduce your net profit
It’s possible to use tax-loss harvesting to reduce your net capital gain all the way to zero. If you have more capital losses than capital gains, you’ll have a net capital loss for the year.
When that happens, you can even deduct up to $3,000 in capital loss from your income, reducing your taxes even further. Any capital loss over $3,000 can be carried forward to later years.
Watch for the wash-sale rule. If you write off capital losses, you have to wait at least 30 days after the sale before you can repurchase it, or the loss will be disallowed for tax purposes.
Here's a deeper dive into how the capital gains tax is calculated.
Try Qualified Opportunity Funds
The IRS designated certain geographical areas as “opportunity zones” due to economic distress. An opportunity fund invests in real estate or business development in these areas.
To encourage investors to help spur economic growth, investors can receive tax breaks for investing via an opportunity fund.
Specifically, you can defer the tax due on gains that are reinvested in opportunity funds. The exact amount of your benefit depends on how long you hold the opportunity fund.
However, be aware that there are inherent risks associated with investing in an opportunity fund such as loss of principal or tax rate changes. Remember, the whole premise is to help economically stressed areas, which can be more volatile environments.
These are also relatively new options, so there isn’t a lot of history to know how these investments fare over the long term. An investment in an opportunity fund may be best for someone looking for additional ways to diversify their money, receive a tax deduction, and feel good about the help they are providing.
Know Your Tax Brackets (And Use Them to Your Advantage)
It’s no secret that the income and capital gains tax brackets are both progressive, meaning the higher your income, the higher the tax rate.
Worried about capital gains taxes? Here's how to reduce capital gains tax on stocks.
You should consider where you are in a given tax bracket before you decide to harvest gains or losses. If you are in a lower tax bracket than average, it may make sense to realize capital gains while your tax rate is lower. If you think your income will be lower shortly (such as when you retire), then consider waiting until then to sell your stock and realize the gain.
If you are in a higher bracket than usual or close to the top of your current bracket, it may make sense to wait and sell your stocks next year to avoid pushing yourself into the next bracket. You can also accelerate deductions by doing things like making two years’ worth of charitable contributions in a single year.
Investors with significant capital gains should also watch out for the net investment income tax. The IRS levies a 3.8% tax on investment income including capital gains (and others) for those who make over $200,000 if filing single or $250,000 married filing jointly. Keep this tax in mind when looking at what gains to realize in a given tax year.
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Add Stock Into Your Estate Plan
The surest way to avoid capital gains tax on stocks is not to realize a capital gain! If you don’t sell your stock during your lifetime, you don’t have any capital gain to pay.
Your heirs may be able to avoid that tax burden too by claiming the step-up in basis. A step-up in basis means that your heirs' basis in the stock will be the value they receive it, regardless of the value you purchased it. That basis is the starting point for determining taxable capital gains.
Realize Capital Gains With A Unified Strategy
Capital gains taxes reduce the value of your investments by lowering the portion of returns that you get to keep. Retaining more money in your pocket can do wonders for your retirement plan, giving you more flexibility and freedom with your spending.
Need help reducing taxes on your investment portfolio?
We're passionate about tax planning around here. For us, tax planning is a crucial component of financial planning.
Let Covenant Wealth Advisors help you navigate these strategies to determine which ones are most beneficial to you and keep your taxes as low as possible.
Schedule a free consultation with a CERTIFIED FINANCIAL PLANNER™ professional to see how we can help you.
About the author:
Senior Financial Advisor
Scott is a Financial Advisor for Covenant Wealth Advisors, a CERTIFIED FINANCIAL PLANNER™ practitioner and a Certified Public Accountant (CPA). He has over 17 years of experience in the financial services industry in the areas of financial planning, tax planning, and investment management.
Disclosures: Covenant Wealth Advisors is a registered investment advisor with offices in Richmond and Williamsburg, VA. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital.
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