By Nicole Louvar, AIF®
Dealing with capital gains taxes? Congratulations! Not that you have to pay taxes, but because you have made wise decisions along the way to earn a return on your investments. Yet, along with celebrating making the right financial decisions, you also have to deal with the looming specter of taxes. Even though taxes are unavoidable, there are some specific things you can do to legally lessen the impact of taxes on your gains.
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 for less than a year will result in a short-term capital gains tax. This means that all the gains you made 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 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 and you lived in the home for at least two years of the five-year period 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 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. 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 are 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.
Source: Fidelity
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 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 there are many nuances that can make certain investment vehicles more tax-efficient than others. For example, although REITs are toward the bottom of the table, 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 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. 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 in which they passed. This eliminates the deceased spouse’s portion of capital gains.
We’re Here to Help
Saving more on your taxes doesn’t have to just stop with capital gains. There are so many more financial options that could help you keep your money in your wallet—many of which you probably wished you had learned when you were younger. But that’s the beauty of partnering with a financial advisor who can guide and benefit you with their years of experience, knowledge, and skills.
At Guided Capital Wealth Management, we utilize our proprietary process, The Paradigm FORMula, to help you create a dynamic plan that can help you reach your financial potential and keep you on track toward achieving your goals. Schedule a FIT meeting using our online calendar or contact us at (832) 975-0711 or info@guidedcapitalwealth.com to learn if we are the right team to guide you on your financial journey.
About Nicole
Nicole Louvar entered the field of financial services in 2000 in a highly specialized role as a commodities trader. She implemented buying and selling strategies for large companies in fast-paced environments. Using her corporate experience and degree in finance, she became Chief Operating Officer for Capital Wealth, a company she founded with her husband, Kyle, in 2018. With her extensive background overseeing business plans and executing trading, it was natural for her to step into the role of creating financial plans for clients. Inspired by her work to help clients reach new milestones, Nicole has now added the role of Financial Advisor to her list of accomplishments. Her passion lies in working with women and helping them become more actively involved in and educated about their finances. Because she spends quality time getting to know her clients, her customized financial plans fit everyone’s unique goals and are supported by sound investment models.
Nicole graduated from New Mexico State University in 1999 with a degree in finance. She currently serves on the NMSU Foundation Board. She and her husband, Kyle, have two daughters who love to play sports. She enjoys volunteering for her girls’ sports teams and at their school. In her free time Nicole loves to cook, travel, and play golf with her family.