Capital gains tax is a significant consideration for stock investors. When you sell an asset for more than what you paid for it, you realize a capital gain. This means that you have made a profit on your investment.
This gain, however, is subject to taxation by the government. The rate at which your capital gains are taxed can substantially impact your overall investment returns.
This makes it very important for investors to focus on expanding their portfolios and be aware of effective tax-saving strategies that can help optimize their returns.
In this article, we’ll look over some strategies to reduce capital gain tax on stocks.
Long-term holding
The idea of long-term holding is a fundamental strategy for lowering capital gains tax on stocks. The difference between short-term and long-term holding periods can greatly impact the amount of gains tax you have to pay.
Profits from the sale of equities held for less than a year are considered short-term gains. These gains are often subject to ordinary income tax, which is frequently much higher than the rates applied to long-term gains.
On the other hand, equities held for longer than a year generate long-term returns. Long-term gains frequently have tax rates that are significantly lower than short-term gains. These lower rates are meant to encourage long-term investing and encourage financial market stability.
Long-term holding does need a lot of patience, though. Longer-term growth of your investments increases the possibility of higher gains and puts you in a better position to benefit from lower capital gains tax rates. Your after-tax results would see a significant impact.
Tax-loss harvesting
By offsetting gains with realized losses, investors can reduce their capital gains taxes through the strategic practice of tax-loss harvesting.
With this strategy, investors can minimize their overall taxable income by selling under-performing or depreciating stocks and generating losses that can be applied to offset capital gains. Although it sounds complicated, if you invest with a robo-advisor like Wealthfront, they can take care of it for you, automatically.
The process
An investor selects stocks in their portfolio that have lost value since purchase when they implement tax-loss harvesting. To realize capital losses, investors would sell the equities that have incurred losses. These losses can be used to offset capital gains from other investments made in the same tax year.
If losses outweigh profits, the excess loss can be carried forward to subsequent tax years and used to offset up to $3,000 of ordinary income.
The wash-sale rule
While tax-loss harvesting can be a powerful strategy, investors need to be aware of the wash-sale rule. This rule keeps shareholders from selling a stock in order to realize a loss and subsequently buying almost similar securities within 30 days of the transaction.
The IRS will invalidate the loss for tax reasons and will be added to the cost basis of the repurchased shares if this regulation is broken.
For instance, if a shareholder sells Stock A at a loss and then buys it back within the allotted 30-day period, the loss on the sale of Stock A will not be deductible. Rather, the loss amount will potentially increase the cost basis of the repurchased shares.
Benefits of tax-Loss harvesting
Tax-loss harvesting offers a number of advantages for investors looking to lower their tax obligations.
Cutbacks on taxable gains
Investors can minimize their annual taxable gains and lower their overall tax obligation by balancing capital gains with realized losses.
Improved portfolio performance
By selling underperforming equities as part of tax-loss harvesting, investors can reallocate their funds to possibly more lucrative investments, potentially enhancing the performance of their portfolio as a whole.
Year-round tax planning
Tax-loss harvesting isn’t just at the end of the year; it can be strategically carried out all year long, enabling investors to react to market conditions and proactively manage their tax liabilities.
Long-term Value
Losses may be carried over to offset future gains even if they cannot be fully offset in the current tax year, giving continuous tax benefits.
Utilize tax-advantaged accounts
Investors have access to effective strategies through tax-advantaged accounts like IRAs and 401(k)s that can help them pay less in capital gains taxes while simultaneously growing their investments. These accounts have special tax advantages that greatly improve an investor’s financial plan.
What are tax-advantaged accounts?
Specialized investment vehicles called tax-advantaged accounts are intended to promote long-term saving and retirement planning. They take many different shapes.
Traditional IRAs
You may be able to lower your taxable income in the year you contribute to a traditional IRA because contributions are frequently tax deductible. The account’s gains accrue tax-deferred, so you won’t have to pay taxes on them until you withdraw the money in retirement.
Withdrawals are then subject to ordinary income tax.
Roth IRAs
Because Roth IRA contributions are made with after-tax funds, they do not immediately qualify for a tax deduction.
However, the main benefit is that provided you satisfy the account’s holding period and other requirements, eligible withdrawals—contributions and gains—are completely tax-free in retirement.
401(k)s
These retirement plans provided by employers also have tax benefits. Most contributions are made with pre-tax money, reducing your current taxable income. Gains in a 401(k) account grow tax-deferred until withdrawal in retirement, just like regular IRAs.
Choosing the right account type
Selecting the right tax-advantaged account depends on your individual financial goals and circumstances.
A typical IRA or 401(k) may be better if you think you’ll be in a lower tax bracket in retirement because the tax deduction now can offset the taxes you’ll have to pay when you withdraw the money.
If you think your tax rate in retirement will be higher or want to take advantage of tax-free growth and withdrawals in retirement, a Roth IRA may be the best option.
Using both traditional and Roth accounts in your portfolio can give you more control over how you’ll handle your tax obligations in retirement. Read more about Roth IRAs vs traditional IRAs to determine which is right for you.
Gift stocks to family members
Giving valued equities to family members is a tax-efficient technique that can help lower your capital gains tax obligation while helping your loved ones. This method entails transferring ownership of appreciated equities to family members in lower tax categories, perhaps resulting in cheaper capital gains taxes upon sale.
When you give valued equities to family members in lower tax categories than you, they may pay a lower capital gains tax rate when they sell the stocks. This method is especially handy for parents who want to financially support their children or for those who want to share the advantages of their investing success with their loved ones.
Strategies for minimizing tax implications
There are some strategies to maximize the benefits of gifting appreciated stocks and minimize tax implications.
Spread gifts across recipients
If you have several family members, you can give each one up to $15,000 in shares. Spreading gifts among family members might help lower the size of your taxable inheritance over time.
Use Both Spouse’s Exclusions
If you’re married, you and your spouse can give up to $15,000 to the same person. This enables a total joint gift of $30,000 without incurring gift tax.
Gifts to Minors
Consider opening custodial accounts (UTMA or UGMA) for your recipients if they are minors. These accounts allow you to handle the minor’s assets until they reach the age of majority, at which point they assume custody of the assets.
Consider the ‘step-pp’ in basis
Giving appreciated stock as a gift can be advantageous, but remember that the recipient’s cost basis for tax purposes will be the original purchase price.
As opposed to if they had inherited the stocks with a ‘step-up’ in basis, the recipient may be subject to a larger capital gains tax obligation if they decide to sell the stocks.
Charitable donations
You can also turn to philanthropy as your strategy. Donating appreciated stocks to charitable or nonprofit organizations lets you support the cause you believe in and get tax benefits.
Donating an appreciated stock to a nonprofit or charitable organization can deduct the stock’s market price from your taxable income. This can lower your overall tax liability for the year you make the donation.
When you sell stocks that have appreciated, you would typically incur capital gains tax on the difference between the price you bought the stock for and the price you sell it for. But you don’t have to pay this tax when you donate this stock. On top of deducting the stock’s purchase price, avoiding capital gains tax also results in savings.
Strategies to maximize benefits
To make the most of donating appreciated stocks, you should remember some strategies.
Choose high-value stocks
If you donate stocks, picking those with a high purchase price and a significant appreciation can lead to larger deductions. It also provides greater benefits for the charitable organization you donate to.
Evaluate holding period
You can maximize your tax benefits by combining donations and long-term holding. Donate stocks that you’ve held for at least a year since this will qualify them for long-term holding savings.
Verify charitable status
Make sure the organization you’re donating to is a qualified charitable organization! Not every nonprofit or charitable organization is recognized by tax authorities and may not qualify for tax benefits. Look into this before you make the donation.
Consult tax professionals
Tax laws can change at any time, and you never know when a tax benefit that was previously applicable will not be any longer. It’s always a good idea to consult a tax professional before you make a donation.
Invest in tax-managed funds
Tax-managed funds are vehicles specifically designed to minimize the tax impact on returns. The focus here is to reduce any transactions that can trigger taxes – including capital gains. There are several strategies for this.
Low portfolio turnover
Tax-managed funds typically come with lower portfolio turnover in comparison to other funds. This means fewer securities are being bought and sold, resulting in fewer capital gains distributions. That is, while returns are made, they are made on fewer securities.
As a very crude example, you’d have to pay a higher amount in capital gains tax if you were paying on the gains for ten securities instead of 5.
Long-term investing & tax loss harvesting
These funds will usually also employ the benefits of long-term gains and tax loss harvesting to reduce the amount you have to pay for the gains you make.
Invest in Exchange-Traded Funds (ETFs)
Exchange-traded funds (ETFs) have become quite popular as investments because of their unique structure, liquidity, and potential tax efficiency.
ETFs offer several advantages over traditional mutual funds, including their tax-efficient nature.
ETFs vs. mutual funds:
Both ETFs and mutual funds pool investors’ money to invest in a diversified portfolio of securities. However, ETFs have distinct features that can make them more tax-efficient.
Intraday trading
ETFs trade on exchanges like individual stocks, allowing investors to buy and sell shares throughout the trading day. This trading feature can lead to better tax management.
In-kind creations & redemptions
ETFs are created by specialized entities, known as Authorized Participants (APs), who assemble a portfolio of securities that matches the ETF’s index or strategy. This basket can be exchanged with the provider in return for ETF shares.
Just like APs can create ETFs, they can also be redeemed. The ETF shares can be returned to the provider in exchange for the underlying securities.
This mechanism allows ETFs to avoid selling securities in the secondary market to accommodate new investments or withdrawals. This results in reduced realization of capital gains within the ETF portfolio, reducing taxable events for all investors in the fund.
Tax efficiency
Since the process can be distributed, ETFs can manage their portfolio without generating many taxable events. In comparison, mutual funds cannot do this, so you’d have more capital gains tax to pay if you chose a mutual fund over an exchange-traded fund.
On top of that, when an investor sells ETF shares on the secondary market, the individual investor realizes any potential capital gains rather than the fund itself. This gives investors better control over the timing of their capital gains, potentially managing their tax liability more effectively.
Some ETFs also engage in tax-loss harvesting, similar to the strategy employed by individual investors.
Using capital losses to offset capital gains
Capital losses can be valuable in managing tax liability on investments. You can offset the gains using your capital losses and reduce your overall tax liability. In fact, in some cases, you can also retain more of your investment profits.
Offsetting capital gains with losses
You incur a capital loss when you sell an investment for a lower price than you bought it. It’s the flip side of a capital gain, where you sell for a higher price than what you purchased it for.
Being on the opposite side of the same coin, you can use the loss to offset the gain.
For example, imagine you have $10,000 in capital gains from selling Stock A and $5,000 in capital losses from selling Stock B. You can apply the $5,000 loss to offset the equivalent portion of the gains. As a result, you would only be taxed on the net gain of $5,000 ($10,000 – $5,000).
Limitations and order of application
It sounds pretty straightforward, but there are some limitations and orders to keep in mind when using this method.
Netting capital gains & losses
Before applying any losses, you have to calculate the total gains and total losses separately and then subtract the total losses from the total gains. If the answer is positive, you have a net gain. If it’s negative, you have a net loss.
You can deduct net losses against other types of income up to a certain limit. This is about $3,000 per year, but you should always keep an eye on tax laws to stay updated on this limit.
Carryover of excess losses
You can also carry over the excess loss to future tax years if your capital losses exceed the capital gains and the annual limit. This means you can use those losses against gains in future years.
Short-term vs. long-term losses
Capital losses can be classified as short-term or long-term, depending on how long an asset has been held. Long-term losses are offset first by long-term gains, while short-term losses are covered first by short-term gains. Both sorts of losses are pitted against one another in the same order if you have both kinds of losses.
Things to keep in mind
While utilizing capital losses to offset gains is a valuable strategy, making informed decisions based on your financial situation is important.
To start, timing the realization of losses and gains strategically can help you maximize the benefits of loss offsetting. You have to be very careful about timing. Otherwise, you could end up losing money.
Also, make sure to think in the long term. While offsetting gains with losses can be beneficial, keeping your long-term investment goals in mind and not making decisions solely for tax purposes is essential.
Final thoughts
Remember, achieving optimal returns isn’t solely about picking the right stocks or timing the market. It’s also about intelligently managing the tax implications of your investment decisions.
You need to combine your tax-saving strategies and use them wisely to maximize your returns and minimize how much you end up losing in taxes.
While it may sound straightforward, the investing world is tricky. If you’re just starting or are not a seasoned investor, it’s a good idea to consult a professional on what to do. Learn when it’s time to hire a financial advisor or find vetted financial advisors in your area now with Paladin Registry:
Paladin Registry is a free directory of financial planners and registered investment advisors (RIAs). The registry has the highest standards for its advisors, and it works with your requirements to find the perfect match.
- Free to use
- Narrowed and vetted pool
- No obligation to move forward
- Requires at least $100,000 in investable assets
