It’s easy to get caught up in choosing investments and forget about the tax consequences, particularly, capital gains tax. After all, picking the right stock or mutual fund can be difficult enough without worrying about after-tax returns. But it’s important to keep consequences in mind, especially for day traders and others taking advantage of the greater ease of trading online.
Factoring in the tax impact is also important when you invest in other types of assets, such as your home.
However, figuring taxes into your overall strategy—and timing when you buy and sell—is crucial to getting the most out of your investments. Here, we look at the capital gains tax and what you can do to minimize it.
Capital Gains – The Basics
A capital gain occurs when you sell an asset for more than you paid for it. Expressed as an equation, that means: Capital Gain = Selling Price − Purchase Price. Just as the government wants a cut of your income, it also expects a cut when you realize a profit on your investments. That cut is the capital gains tax.
Capital Gains Rates for 2021
While the tax rates for individuals’ ordinary income are 10%, 12%, 22%, 24%, 32%, 35%, and 37%, long-term capital gains rates are taxed at different, generally lower rates. The basic capital gains rates are 0%, 15%, and 20%, depending on your taxable income.
Short-Term vs. Long-Term Capital Gains
The tax you’ll pay on a capital gain depends on how long you hold the asset before selling it.
To qualify for the more favorable long-term capital gains rates, assets must be held for more than one year. Gains on assets you’ve held for one year or less are short-term capital gains, which are taxed at your higher, ordinary income tax rate. Please note, there are limited exceptions to the one-year holding period rule.
Four Ways to Minimize or Avoid Capital Gains Tax
There are a number of things you can do to minimize or even avoid capital gains taxes such as:
- Invest For The Long Term
If you manage to find great companies and hold their stock for the long term, you will pay the lowest rate of capital gains tax. Of course, this is easier said than done. A company’s fortunes can change over the years, and there are many reasons you might want or need to sell earlier than you originally anticipated.
- Take Advantage of Tax-Deferred Retirement Plans
When you invest your money through a retirement plan, such as a 401(k), 403(b), or IRA, it will grow without being subject to immediate taxes. You can also buy and sell investments within your retirement account without triggering capital gains tax.
In the case of traditional retirement accounts, your gains will be taxed as ordinary income when you withdraw money, but by then you may be in a lower tax bracket than when you were working. With Roth IRA accounts, however, the money you withdraw will be tax-free, as long as you follow the relevant rules.
For investments outside of these accounts, it might behoove investors who are near retirement to wait until they actually stop working to sell. If their retirement income is low enough, their capital gains tax bill might be reduced or they may be able to avoid paying any capital gains tax. But if they’re already in one of the “no-pay” brackets, there’s a key factor to keep in mind: If the capital gain is large enough, it could increase their total taxable income to a level where they’d incur a tax bill on their gains.
- Use Capital Losses to Offset Gains
You can use capital losses to offset your capital gains as well as a portion of your regular income. Any amount that’s leftover after that can be carried over to future years.
If you experience an investment loss, you can take advantage of it by decreasing the tax on your gains on other investments. Say you own two stocks, one of which is worth 10% more than you paid for it, while the other is worth 5% less. If you sold both stocks, the loss on the one would reduce the capital gains tax you’d owe on the other. Obviously, in an ideal situation, all of your investments would appreciate, but losses do happen, and this is one way to get some benefit from them.
If you have a capital loss that’s greater than your capital gain, you can use up to $3,000 of it to offset ordinary income for the year. After that, you can carry over the loss to future tax years until it is exhausted.1
- Watch Your Holding Periods
If you are selling a security that you bought about a year ago, be sure to find out the trade date of the purchase. Waiting a few days or weeks in order to qualify for long-term capital gains treatment might be a wise move as long as the price of the investment is holding relatively steady.
Will I Have to Pay Capital Gains Tax on the Sale of My Home?
If you have less than a $250,000 gain on the sale of your home (or $500,000 if you’re married filing jointly), you will not have to pay capital gains tax on the sale of your home. There are certain criteria you must meet to qualify for this exemption. You must have lived in the home for a total of two of the previous five years, and the exemption is only allowable once every two years. If your gain exceeds the exemption amount, you will have to pay capital gains tax on the excess.
KEY TAKEAWAYS
- A capital gain occurs when you sell an asset for more than you paid for it.
- If you hold an investment for more than a year before selling, your profit is typically considered a long-term gain and is taxed at a lower rate.
- You can minimize or avoid capital gains taxes by investing for the long term, using tax-advantaged retirement plans, and offsetting capital gains with capital losses.