4 Strategies to Reduce Capital Gains Tax
By Marjorie L. Rand, CPA, CFP®, RICP®
When it comes to paying taxes, not all of it is bad. That statement may sound controversial, but capital gains taxes are one example. Of course, you are still paying a tax that is due, but in this instance, it means you have recently sold an asset and can cash in on the appreciation. That’s a good problem to have. But all good things come at a cost, and those gains will also come with a tax bill. Fortunately, there are strategies you can use to reduce capital gains taxes. Use these four tips to minimize your tax liability and keep more of your earnings.
1. Consider Delaying the Sale
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 make from the sale of the stock will be taxed at your ordinary income rate, 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, 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 years before the sale, the IRS allows you to exclude the first $250,000 of capital gains (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. Take Advantage of 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 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. Be Aware of Asset Location
Some investments can be more tax-efficient than others. For example, a municipal bond is considered the most tax-efficient security because income from municipal bonds is 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, assets at the top are more tax-efficient than assets at the bottom.
Source: Fidelity
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 many nuances can make certain investment vehicles more tax-efficient than others. For example, although REITs are at 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. Learn About 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.” 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 for You
If you’re required to pay capital gains tax on the sale of an asset, that’s a sign you are doing something right with your investments. And because tackling the intricacies of taxes is a crucial aspect of financial planning, you need a financial professional who can help you make sense of all the types of taxes you’ll face at different times in your financial life and in different circumstances. That’s where I come in.
At Rand Financial Planning, as a CPA and CFP® professional, I can provide guidance on tax-efficient strategies and recommend tax-sensitive investment strategies by taking into account income and deductions, Social Security benefits, and required minimum distributions (RMDs), in addition to non-retirement accounts. I also regularly evaluate potential Roth conversions to minimize taxes in retirement.
While it’s wise to try to minimize your tax liability, this is only one component of your overall financial well-being. I help clients pursue their financial goals by taking a comprehensive approach that looks at all aspects of their financial situation to provide the most tax-efficient retirement plan customized to their needs.
Schedule a 20-minute introductory call or reach out to me at 908-895-2406 or marge@randfinancialplanning.com to see if I’m the right fit to help you on your financial journey.
About Marge
Marjorie Rand is founder and financial advisor at Rand Financial Planning, a comprehensive, fee-only, fiduciary financial planning firm based in Flemington, New Jersey. Marge specializes in helping her clients plan for a secure retirement and navigate life’s many transitions through customized, tax-efficient retirement planning. She is passionate about empowering her clients to make the best financial decisions for their lives and being by their side no matter what life throws at them. Marjorie spent many years as a CPA, specializing in estates, before founding Rand Financial Planning so she could be a go-to source for all her clients’ financial needs and help them avoid costly mistakes. She has a bachelor’s degree in accounting from Rutgers University and a Master of Science in Taxation from Fairleigh Dickinson University, along with the Retirement Income Certified Professional® (RICP®) and CERTIFIED FINANCIAL PLANNER™ certifications. When she’s not working, Marge enjoys boating, horseback riding, traveling, and hiking with her husband and her dog, Rangeley. To learn more about Marjorie, connect with her on LinkedIn.