Capital gains taxes are a tax on your investment earnings that you may owe if you invest through a taxable brokerage account. The good news is that there are strategies investors can use to eliminate or minimize these taxes. The right ways for you will depend on your long-term financial goals. If you are unsure of the path to take to avoid taxes, you can work with a professional financial advisor who can help you create a financial plan and provide the right ways to avoid these taxes.
What are capital gains taxes?
Capital gains taxes are taxes due when you sell an asset for a profit. Tax rates vary depending on how long you’ve held the shares. If you sell it at a loss, you owe no taxes on that transaction. So a capital gain on a stock you own would be the profit you receive that is above what you originally paid for those shares.
For example, if you bought one share of XYZ Corporation at $10 and ended up selling it for $100, your capital gain would be taxed on the difference of $90. How long you hold this asset will depend on whether it is a long-term or short-term gain. There is a difference in determining how these taxes are treated and the rate at which you will have to pay.
Short term capital gains: When you hold the stock for a year or less, these are called short-term capital gains. Short-term capital gains tax rates have the same income tax rates as ordinary income, such as money earned from a job.
Long term capital gains: Long-term capital gains offer preferential treatment in the federal tax code. These income tax rates are lower than ordinary income tax rates with a maximum tax rate of 20%. In some cases, long-term capital gains tax rates can be as low as 0%.
How capital gains on shares are taxed
The tax rates on the capital gains you earn on your stocks will be determined by both your tax filing status and your adjusted gross income (AGI). You will end up being taxed between 0% and 20% of your profit, depending on your state. You’ll likely end up paying either 15% or 20% if your AGI is greater than either $41,676 as a single filer or $83,350 as a married couple filing jointly.
In addition to capital gains tax, high net worth individuals or high income earners may end up on the hook for additional taxes on their investment gains. The net investment income tax can add an additional 3.8% tax on top of the capital gains tax if your modified adjusted gross income (MAGI) is over $200,000 for single filers or $250,000 for married filing jointly.
9 Ways to Avoid Capital Gains Taxes on Stocks
There are many strategies investors can implement to reduce or avoid capital gains tax on stocks sold at a profit. Here are some of the more common methods you can incorporate into your financial plan.
1. Invest for the long term
When you invest for the long term, you benefit from long-term capital gains rates. These tax rates can be significantly lower than ordinary income tax rates. In 2022, if your taxable income is less than $40,400 as a single person ($80,800 for married filing jointly), the long-term capital gains tax rate is 0%.
2. Contribute to your retirement accounts
Investing in retirement accounts eliminates capital gains taxes on your portfolio. You can buy and sell stocks, bonds and other assets without triggering capital gains taxes. Withdrawals from traditional IRAs, 401(k) and similar accounts may result in ordinary income taxes. However, Roth accounts eliminate taxes entirely on eligible withdrawals.
3. Choose your cost base
When selling your shares, it is possible to choose the cost basis based on the shares you are selling. By hand-picking individual stocks, you may be able to avoid capital gains taxes by selling stocks that are losing (or at least lower-earning), even if your overall position in that investment has made money.
4. Lower your tax bracket
When you have less taxable income, you may qualify for 0% tax rates on long-term capital gains. You can lower your taxable income if you are strategic about your withdrawals. For example, retirees can make withdrawals from a Roth IRA instead of a 401(k) or traditional IRA, since Roth withdrawals are tax-free in retirement. Alternatively, you can maximize your deductions by prepaying your property tax payments before December 31 or by rolling two years’ worth of charitable contributions into one year. Another option to avoid being bumped into a higher tax bracket is to defer income and maximize your deductions. Maxing out your company retirement accounts and health savings accounts (HSAs) is a great way to reduce your taxable income as well.
5. Harvest losses to offset profits
Capital losses from investments can offset realized short-term and long-term capital gains. Some investors preemptively harvest losses when investments decline in value to offset potential future capital gains. Investors can also offset $3,000 in regular income per year if they have excess capital losses.
6. Move to a Tax State
While the state you live in won’t affect the federal taxes you owe, moving to a tax-friendly state can help you avoid capital gains tax on stocks when you pay state income taxes. Nine states do not charge capital gains taxes. The states are Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming.
7. Donate stock to charity
If you have appreciated the stock, consider donating the stock instead of cash to your favorite charity. You won’t owe capital gains taxes on the earnings when you transfer those shares directly to the charity. Plus, you’ll get a tax deduction based on the current value of the shares instead of the actual amount you paid for them. And the charity won’t owe taxes either, making it a win-win for both parties.
8. Invest in an opportunity zone
The Tax Cuts and Jobs Act created “opportunity zones” that offer tax advantages to investors. By investing in eligible low-income and disadvantaged communities, you can defer taxes and potentially avoid capital gains tax on stocks altogether. To qualify, you must invest unrealized gains within 180 days of selling shares in an eligible mutual fund and then hold the investment for at least 10 years.
9. Transfer the valued assets
When someone dies, the cost basis of their assets increases. This means that heirs who receive stocks, bonds, real estate and other assets do not owe capital gains taxes if they sell the assets immediately. If the assets continue to appreciate after the investor’s death, the beneficiaries will only owe taxes on the appreciation that occurred after their date of death.
The bottom line
Capital gains taxes can hurt your investment earnings, especially if you’ve held the assets for a year or less. Fortunately, there are many strategies investors can use to reduce or avoid capital gains tax on stocks, bonds and other assets. Before making any moves, talk to a financial planner or tax advisor to discuss your current situation and the strategies you’re considering.
Advice on tax planning
Investors with a financial advisor can work together to reduce or avoid capital gains tax on stocks and other investments. Using their experience and knowledge, a financial advisor can recommend steps to minimize the taxes you will owe on your stock sales. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors serving your area, and you can interview your advisors at no cost to decide who is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Capital gains taxes reduce the profits you’ve earned from your investments. You can properly plan what your potential liabilities might be by planning in advance how your investments will grow. Use our investment calculator to find out what your potential raise might be.
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