By Jake Withnell, CFP®
For high-income earners and successful investors, capital gains tax can be the bane of your existence. You made the right investment decisions and now you’re on the hook for capital gains tax if you want to cash in on the appreciation. As frustrating as it is, the price of successful investments is usually capital gains tax.
Thankfully, though, there are ways to minimize your tax liability and keep more of your gains in your pocket. Here are four strategies to reduce your capital gains tax and keep the IRS at bay.
1. Hold Off on Selling
Timing the sale of your investments is a critical component when trying to reduce your capital gains tax. This is because capital gains are divided into two categories: short term and long term.
If you sell an appreciated asset before owning it for more than a year, the appreciation will be subject to a short-term capital gains tax. This means that all the appreciation made from the sale of the asset will be taxed at your ordinary income rate, which can be as high as 37% for those in the top tax bracket. If, however, you hold the asset for more than one year, you will be taxed at the preferential long-term capital gains tax rate, which caps out at 20%. (1)
Holding periods are also critical for all types of investments, including stocks, stock options, and real estate. With real estate in particular, you may be eligible for a capital gains exclusion if you sell your primary residence after living in the home for at least two years of the five years prior to sale. If you meet the requirements, the IRS will allow you to exclude the first $250,000 of capital gains (or $500,000 for a married couple filing jointly) from your income. (2) 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
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. (3) 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.
Keep in mind that there are restrictions with this strategy, namely the wash sale rules. The IRS prohibits tax deductions if an investor sells a security at a loss and then purchases the same or “substantially similar” security within 30 days. (4) This is an important limitation to keep in mind, as investors often replace losses with similar securities in order to maintain a specific asset allocation. One way around this rule is to purchase a mutual fund or ETF that targets the same sector as the stock you sold.
3. Asset Location Strategy
Some investments will be more tax-efficient than others. For example, a municipal bond is considered the most tax-efficient investment because income from municipal bonds is tax-exempt on a federal level and may be state tax-exempt in certain cases. Investments like high-yield bonds are considered less tax-efficient because interest payments are taxed as ordinary income.
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 pre-tax dollars; in this case, contributions are not taxed until you withdraw them, typically in retirement when your income is generally lower.
An asset location strategy aims to pair tax-advantaged accounts with tax-inefficient assets and tax-inefficient accounts with tax-advantaged assets. In this way, you can make the most of the legal tax advantages available with various assets and accounts.
For instance, you may choose to invest a tax-advantaged account like a 401(k) in tax-inefficient assets like high-yield bonds. Similarly, you may pair fully taxable accounts (individual, joint, trust, etc.) with more tax-efficient assets like municipal bonds. Placing investments that have higher tax rates with accounts that delay taxes will help reduce the amount you owe.
Municipal bonds, for instance, are investments that typically earn lower pre-tax yields than other bond options, but they are not subject to federal income tax. This makes them particularly attractive to high-income earners since, on a tax-equivalent basis, the yields are often higher than fully taxable bonds. Because of the tax advantages available to municipal bonds, there is no use placing them in a tax-advantaged account because there are essentially 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. 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 purchased. If you have made multiple purchases of the same stock, each purchase is assigned 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 is another strategy that can be used to reduce capital gains tax. This is because assets passed through inheritance receive a “step up” in cost basis, meaning your heirs will only pay capital gains tax on the appreciation that occurs after you pass away. (5) For example, when assets pass via inheritance to a surviving child, they will receive a cost basis equal to the fair market value of the asset on the day on which the parent passed. This eliminates any capital gains that may have accumulated up to that point.
Understanding this rule can help you structure your assets in a way that will reduce your overall capital gains tax liability. Some gift highly appreciated assets right before they pass, not knowing that they have created a huge tax liability for the recipient. Choosing instead to pass on the property through a will or a trust can help minimize the tax liability for your heirs.
We’re Here to Help
Minimizing capital gains taxes is only one component of a sound financial plan. After all, there are no capital gains taxes without successful investment strategies. If you would like more information on how JGP Wealth Management can help optimize your long-term financial plan, we would love to hear from you! Reach out to us at 503-446-6450, email firstname.lastname@example.org, or schedule an introductory phone call online.
Jake Withnell is a financial advisor at JGP Wealth Management, an independent, fee-based financial advisory firm in Portland, Oregon. Jake is known for going the extra mile for his clients and for his passion for working tirelessly to help his clients find solutions to their financial concerns so they can confidently live out the life they want. He prioritizes listening and understanding as the foundation of his relationships with his clients, and his highest hope is that they can spend more of their time and energy on their passions knowing he is watching over their financial future. Jake specializes in serving business owners, Nike executives, and retirees, and plays a key role in JGP’s portfolio management process, building and analyzing financial models, and conducting client cash flow analyses.
Jake graduated from Eastern Washington University with a bachelor’s degree in professional accounting and finance. He is a Certified Public Accountant (CPA) and a CERTIFIED FINANCIAL PLANNER™ professional. Jake’s claim to fame is his time playing tight end for the Eastern Washington University Eagles, all while earning four-time Big Sky Conference First Team All-Academic honors! Jake values giving back to his community and does this by volunteering with the Children’s Cancer Association, Family Building Blocks, and New Avenues for Youth. In his free time, Jake takes advantage of the many outdoor activities the Northwest has to offer, such as trail running, mountain biking, and hiking. He loves traveling and spending long weekends at his family beach house in Seaside, OR. To learn more about Jake, connect with him on LinkedIn. You can also watch his latest webinar on 6 Ways to Maximize Your Nike Employee Benefits.