Are your investments in a gain position? If yes, you’re in a good spot. It’s always better to be in a gain than a loss, but that also means you may have a tax liability hanging over your head.
According to the IRS, the tax rate on most net capital gains is no higher than 15% for most individuals. Some or all net capital gains may be taxed at 0% if your taxable income is less than or equal to $44,626 for single, or $89,250 for married filing jointly or for a qualifying widow/widower.
With this rule in mind, let’s look at how you can utilize the rest of your portfolio to minimize your capital gains tax liability.
1. Wait a Little Longer to Sell
Timing the sale of your investments is critical to lowering your capital gains taxes. Selling your shares after holding them for less than a year will result in a short-term capital gains tax. This means that all of 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 change the tax rate, and your asset 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 where you lived for at least two 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. Utilize Tax-Loss Harvesting (TLH)
Losing money on your investments is usually bad 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. Asset Location
Some investments will 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.
For illustrative purposes only. Relocating tax-inefficient assets from a taxable to a tax-advantaged account will be a taxable event and those tax consequences need to be factored into the asset relocation decisions.
Like assets, there are more tax-friendly investment accounts. 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 chart, 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 specifics of each financial instrument to your advantage.
4. Understand Cost Basis and Share Lots
When you buy any stock, the stock is assigned a lot number regardless of the number of shares you buy. 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 of death. This eliminates the deceased spouse’s portion of capital gains.
Let Us Help
Minimizing capital gains taxes is one part of an overall financial strategy. After all, the goal is to increase your gains while minimizing your taxes. Wondering how else you can reduce taxes and set yourself up for long-term financial success? We at Black Walnut Wealth Management would love to help. Schedule a 15-minute introductory meeting by calling us at (231) 421-7711 or using our online calendar.
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