By Paul S. McNulty, CFP®
As we watch the market go up and down and then up again, we rarely think about the taxes we might pay with the rise of our portfolio or home value. But we should, because the tax man always cometh. Thankfully, you aren’t completely powerless when it comes to capital gains tax—you can control how much you owe.
The amount of taxes you pay is dependent on the amount of time you hold your asset. Having an investment for a year or less will trigger short-term capital gains taxes, which are taxed as ordinary income, as high as 37% in some cases. Long-term capital gains taxes are based on your income and are taxed at 0%, 15%, and 20%. (1) While the simplest way to pay lower capital gains taxes is to hold your asset for more than a year, there are other strategies to help you avoid paying taxes altogether.
Use Tax-Deferred Accounts
Saving for retirement is one way to avoid taxes on capital gains. Trading in a 401(k) or traditional IRA does not trigger capital gains. It does so only when you withdraw the money when it’s taxed as ordinary income. But if you are at retirement age, odds are you will be in a lower tax bracket. A Roth IRA, on the other hand, is tax-free, as long as you are 59½ and have held the Roth for more than five years.
Strategize Your Gains & Losses
Not all your stock picks are going to be winners. There are times when you have to bail out of a sinking ship. Tax-loss harvesting is a strategy that allows you to offset your capital gains by capital losses. If you own a losing bond, mutual fund, or stock in accounts other than your 401(k) or IRA, review your realized and unrealized gains and losses. You might be able to offset some of your gains by selling some losses and thus lower your taxable income. And if you live in a high-tax state, you may want to defer tax by deducting up to $3,000 of capital losses in excess of capital gains and carrying any leftover capital losses forward into future years. (2)
Cost basis is another piece of the capital gains tax puzzle you need to keep in mind. Cost basis is the amount you paid for your asset. There are many ways to decide what cost basis to use if you have multiple asset purchases in different periods. Most investors use the first-in, first-out method (FIFO), but there are methods such as last-in, first-out (LIFO), and average cost. If these accounting terms seem like a foreign language, then it’s best to consult your financial advisor and CPA before taking advantage of this option.
Check The Rules On Your Other Assets
Another asset that incurs capital gains tax when sold is your house. The IRS allows you to exclude $250,000 of capital gains, or $500,000 if married filing jointly, but you have to own your property for more than two years and it must be your primary residence. (3) Even better, you can claim this exclusion on another property in the future, as long as it’s been more than 2 years since you previously claimed it.
Do You Have More Capital Gains Questions?
You likely do. Capital gains taxes can get complicated quickly. There are many alternative strategies for those who want to offset or defer capital gains taxes or need to structure their income in a way that minimizes taxes. Luckily, you can pass your tax headaches on to us at Boston Metro Advisor. We can help you examine your options to ensure that your investments are operating at their full potential and you won’t face unnecessary tax penalties down the road.
Paul McNulty is the founder of Boston Metro Advisor with over 20 years of experience helping people navigate the ups and downs of the economy toward the financial future they envision. His education consists of a Bachelor of Science in business administration from the University of Rhode Island and the CERTIFIED FINANCIAL PLANNER™ (CFP®) professional designation.
Paul’s experience and education have made him a multi-faceted professional capable of assisting people with virtually all their financial needs. His services include every facet of retirement planning, from 401(k) rollover services and income planning to wealth management and estate planning. Paul has been active in his community over the years as a youth sports coach. When he’s not spending time with his wife, Cindy, and their two children, who are both recent college graduates, Paul enjoys reading, playing golf, and fishing. Learn more about Paul by connecting with him on LinkedIn.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.