Income tax planning comes in many different forms, but effective capital gains planning often has the biggest long-term impact on the wealth of successful people.
What Are Capital Gains And How Are They Taxed?
In general, when you sell an asset, you either receive more than you originally paid for it (a capital gain) or less than you originally paid for it (a capital loss). The exception to this special treatment is sales in the ordinary course of business, such as selling inventory, which is taxed as ordinary income. Some examples of assets that could be sold for a capital gain include real estate, mutual funds, stocks and bonds.
Most income is taxed at ordinary income tax rates and occurs on a timetable that is outside of your control. By contrast, long-term capital gains are taxed at a lower rate, and the timing of capital gains is often up to you. These features lead to some major planning opportunities for those who know what to consider.
Your tax rate on capital gains is determined by how long you owned the asset in question and by your marginal tax bracket. If you own an asset for less than one year, capital gains are taxed just like ordinary income, up to a maximum of 37%. For assets you hold for a year or longer, which are considered long-term, the capital gains tax bracket is lower, though it is also determined — in most cases — by your taxable income and your filing status (see chart below). Collectibles held for the long term are taxed at a 28% rate, regardless of your taxable income. If you claimed depreciation on a business asset, that amount is recovered at a special 25% rate. In general, though, the easiest planning opportunity is to be sure to hold investments for more than one year to qualify for the more beneficial long-term capital gains tax rate.
Long-Term Capital Gains Tax Rates For 2022
|Filing Status||0% Rate||15% Rate||20% Rate|
|Single||Up to $41,675||$41,676 - $459,750||Over $459,750|
|Married Filing Jointly||Up to $83,350||$83,351-$517,200||Over $517,200|
|Married Filing Separately||Up to $41,675||$41,676-$258,600||Over $258,600|
|Head of Household||Up to $55,800||$55,801-$488,500||Over $488,500|
Taxpayers may also face a 3.8% surtax on their net investment income. For more information on when and how the government levies this surtax, see the article “Medicare Surtax Planning” by our colleagues Anthony Criscuolo and Melinda Kibler.
Some realized capital gains are subject to special Internal Revenue Code provisions that allow you to avoid paying tax on the full amount of appreciation. The most common example of this is the primary home sale exclusion. The tax code allows single taxpayers to exclude up to $250,000 in capital gains on the sale of a primary residence. Taxpayers who are married and file jointly can exclude up to $500,000. To qualify for the exclusion, you must own the home and have used it as your principal residence for two of the past five years. (The two years do not have to be sequential.) In most cases, taxpayers may only claim this exclusion once within a two-year period. Another popular exclusion has to do with qualified small business stock sales, which we will discuss in more depth in part two of this series.
Strategies To Defer Or Reduce Capital Gains Taxes
Many strategies exist to defer or reduce capital gains taxes. Paired with proper timing, one or more of these approaches can help you minimize your capital gain’s tax impact. It is important to note that there is no one-size-fits-all solution to reducing your capital gains tax liability. You may find that a combination of strategies works best for you. In some cases, you may even be able to eliminate net capital gains taxes entirely.
Be Mindful Of Asset Location
Retirement plans are great vehicles to avoid capital gains tax. Participating in a traditional 401(k) or individual retirement account ensures that you do not pay tax on any investments you sell until you withdraw assets from the plan. This is why you will sometimes see these retirement accounts called “tax deferred.” However, when you withdraw the funds in retirement, you will owe tax at ordinary income tax rates, even if you held the underlying securities for a year or more. This disadvantage is offset by the fact that contributing to a tax deferred retirement plan entitles you to a deduction on your current year’s income taxes, and many people occupy a lower tax bracket during retirement than while they are working. In contrast, in a Roth IRA or Roth 401(k), you forgo immediate income tax benefits by contributing after-tax assets to the account. The upside is that any appreciation in the account is fully tax free, since you will not owe tax on qualified withdrawals.
Different types of investments generate different types of income. By putting assets with the highest growth potential in a Roth IRA, you can avoid capital gains in taxable accounts. In addition, putting investments that you expect to trade frequently, or that generate a lot of ordinary income on an annual basis, in a traditional IRA will allow you to benefit from the tax deferral of annual gains. Be mindful, however, of the trade-off of eventually paying ordinary income tax on traditional retirement account distributions versus saving on annual taxes.
Consider Your Annual Tax Bracket
Beyond waiting for an asset to qualify for long-term capital gains tax treatment, it is also important to consider your overall income situation each year. The straightforward question is whether your capital gains will qualify for the 0%, 15% or 20% rate. However, the actual math is not as straightforward as you might imagine. Due to the interaction of ordinary tax brackets and capital gains brackets, the marginal tax on capital gains you realize can actually be as high as 40% at certain levels of income. The full details of these so-called “capital gains bump zones” are beyond the scope of this article. A financial planner can help you to understand your full tax picture, in part by running tax projections before you realize your gains — or decide to wait.
Select Tax Lots In Taxable Accounts
Another tool that you can use to realize long-term capital gains in a tax efficient way is the ability to sell specific lots. These are particular securities that you bought on a certain date. Most brokerage platforms operate on either an average cost method or a “first in, first out,” (or FIFO) method when you want to sell only part of your holding. FIFO or average cost methods can trigger higher capital gains in some cases, however. In most cases, you can issue specific directions for a sale, including selling the highest cost shares first. The steps involved will depend on your brokerage. Investors should be sure to understand the process and specify selected lots when necessary to ensure that they do not pay more tax than they must.
Harvest Tax Losses
When you sell a capital asset for less than its cost basis — usually its purchase price — the end result is a capital loss. While it is never pleasant to lose money on an investment, capital losses do have an upside; taxpayers can use them to offset capital gains for the same year. To the extent that realized capital losses exceed capital gains, up to $3,000 of those capital losses can also be used to reduce tax on ordinary income. (This amount is reduced to $1,500 for married taxpayers filing separately.) Taxpayers can carry forward any capital losses beyond the $3,000 limit to offset future realized gains or ordinary income, too.
Be mindful of Internal Revenue Service rules when you harvest capital losses. Selling investments at a loss for the tax advantage and buying the same investment within 30 days before or after the sale will trigger what is known as the wash sale rule. A wash sale will disallow any of the losses realized from the sale of the investment.
Alongside harvesting capital losses, you can harvest capital gains at opportune times during years in which your taxable income is less. A variety of situations could cause an individual to fall into a lower tax bracket, from the loss of a job to retiring before required minimum distributions take effect. Even without any change in your tax bracket, realizing gains could have tax advantages depending on your situation. For example, you may want to sell a position in an appreciated stock over several years to stretch the horizon of the tax consequences. You could sell a portion of the position at the end of 2022, another portion during 2023, and another in the beginning of 2024, distributing the capital gains taxes over three tax years instead of realizing them all at once.
Pay The Tax Now
Given the relatively low current tax rates on long-term capital gains, some investors will be happy enough to simply sell when it is convenient and pay the tax. The prospect of lawmakers potentially raising capital gains tax rates could lead those on the fence to sell sooner to take advantage of current rates.
Another simple option is to make a gift of the appreciated investments to your children, assuming they are older than 18 and their income is relatively low. (Children under 18 — or 24 in certain circumstances — are subject to the so-called “kiddie tax” rules, which can complicate this strategy.) Your children’s lower tax brackets mean they would owe minimal, if any, taxes on any future capital gains. If you were to sell the appreciated investments and give your children the proceeds in cash, your gift would be reduced by the amount of capital gains tax you owed. This strategy generally works whenever the parent’s tax rate on capital gains is higher than the children’s rate. Note that if the appreciated assets are worth more than the annual federal gift tax exclusion — $16,000 in 2022 — the gift could have other tax consequences for the giver. (To learn more about the annual exclusion and federal gift tax, see our colleague Eric Meermann’s article “Timely Estate Strategies For An Opportune Moment.”)
Give Appreciated Assets To Charity
You can also avoid paying taxes on capital gains entirely by giving or bequeathing appreciated assets to a tax-exempt charity. The charity can sell the asset without owing any tax on the appreciation; many organizations have established brokerage accounts to receive and encourage these sorts of gifts. Giving appreciated property during your lifetime will usually provide you with a tax deduction if you itemize your deductions. These deductions are subject to certain limits, which are beyond the scope of this article. Bequests of appreciated property to charity will typically not produce an income tax deduction, although they can save money for large estates that are subject to estate taxes. We will discuss additional information on charitable giving strategies in part two of this series.
Hold Assets For A Step-Up In Basis At Death
Holding appreciated investments until your death is another proven method of avoiding capital gains tax. When a beneficiary receives an asset, like real estate, upon the original owner’s death, the beneficiary’s tax basis in the asset is “stepped up” (or stepped down, for assets that have declined in value) to the asset’s fair market value on the date of the giver’s death. If the beneficiary sells the asset soon after the original owner dies, the basis step-up can effectively wipe away most, if not all, capital gains tax on the sale. Even if the beneficiary holds the asset, his or her eventual gain will be less, since your original cost basis is no longer the starting point.
Tax Planning Pitfalls To Avoid
While it is important to be mindful of the tax consequences when you sell an asset, you should also stay true to your broader investment objectives. Maintaining a disciplined, long-term financial strategy is critical. Focusing too much on tax planning as the sole driver of your investment decisions may result in worse outcomes. You should not hold on to an investment that no longer fits your goals simply to avoid paying tax on the capital gain. Your investment strategy should focus not on what you make on a pretax basis, but instead on what you keep after paying all taxes, including capital gains.
The capital gains tax planning strategies in this article have been relatively straightforward, but many investors can substantially reduce their tax bills by applying them. In part two of this series, we will explore some advanced planning techniques with more specific applications.