Benjamin Franklin once said, “In this world, nothing can be said to be certain, except death and taxes.” While there’s no avoiding taxation, there are several ways to minimize your tax bill each year. Deductions and credits are well-known ways to reduce regular income tax, but investors shouldn’t ignore the impact of capital gains taxes on investment income.
Let’s take a look at five ways to cut down on your capital gains tax, as well as the easiest ways to make it happen.
Be a Long-Term Investor
Several studies have shown that long-term investors outperform short-term traders. According to Standard and Poor, the majority of active managers underperformed the S&P 500 index for a ninth consecutive year in 2018. There are many different reasons for this underperformance — including the higher tax rates paid for short-term trades.
Capital gains are taxed at two different rates depending on the holding period:
- Short-term capital gains tax applies to the sale of assets held for one year or less. These tax rates are equal to your ordinary income tax bracket during a given year.
- Long-term capital gains tax applies to the sale of assets held for more than one year. These tax rates are 0%, 15%, or 20%, depending on your taxable income and filing status.
Ordinary Income Tax Brackets – Source: TaxFoundation.org
Suppose that you are a single filer that earned $100,000 this year. If you realized $10,000 in short-term capital gains, you would be responsible for paying $2,400 in tax, assuming a 24% taxable income bracket. If the same $10,000 was taxed as long-term capital gains, you would owe just $1,500, assuming a 15% capital gains tax bracket — a 37.5% or $900 savings.
The takeaway: You can lower your capital gains tax bill by holding assets for more than one year.
Offset Gains with Losses
Capital gains are offset by losses on your tax return — you only owe tax on your *net* capital gain. If you had a $1,000 gain from the sale of one stock and an $800 loss from the sale of another stock, your capital gain for the year would only be $200. Selling assets at a loss is therefore one way to reduce your capital gains tax for the year.
The idea of realizing losses for tax purposes is known as *tax loss harvesting*. The process involves selling any losing positions at the end of each year to realize the loss and then buying similar investments to maintain your asset allocation. The goal is to reduce your tax burden for the year without actually impacting your portfolio makeup.
The challenge is avoiding the Wash Sale Rule, which doesn’t permit buying “substantially identical” securities within 30 days before or after the date you sold the loss-generating asset. For example, you cannot sell one S&P 500 index ETF and purchase another S&P 500 index ETF, but you can sell an S&P 500 index ETF and buy a Russell 2000 index ETF.
The takeaway: You can lower your capital gains tax bill by selling losing assets at the end of each year and replacing them with alternatives.
Optimize Cost Basis Methods
The cost basis is the price that you paid for an asset along with any brokerage costs or commissions. While this seems straightforward on the surface, most of us have acquired stock over a period of time through dividend reinvestments, additional contributions, or rebalancing. The way that you calculate the cost basis in these cases can have a big impact on your tax bill.
The many options for calculating cost basis are:
- FIFO, or first-in-first-out, is the default method at most brokers. In this case, you sell your oldest shares first. It’s good for creating long-term gains, but could also create the largest gains if your shares have appreciated over time.
- LIFO, or last-in-first-out, is more likely to trigger short-term capital gains, but also has, potentially, the smallest gain.
- The average cost method involves calculating the per-share average of all purchases over time.
- The actual cost method involves tracking the actual cost of each lot of shares purchased over time.
The actual cost method gives you the most control, but requires additional work. You will need to select the sale shares prior to the settlement of the trade. It may be the best option for minimizing capital gains tax when tax loss harvesting since you can designate higher cost shares to sell and increase the amount of the realized loss. You should speak with your accountant or brokerage to learn more about how to select the appropriate cost basis method to minimize your taxes.
The takeaway: You can lower your capital gains tax bill by using different methods for calculating your cost basis.
Carry Forward Capital Losses
Most investors have experienced a significant loss at some point, but there are some opportunities that arise from these depressing situations. In addition to offsetting capital gains, losses can offset up to $3,000 of income on a joint tax return during a given year. You can even carry forward the losses to future years to help offset future income or capital gains.
There’s no limit to the carry forward of capital losses, which means that ugly markets, such as the 2008 financial crisis, can lead to tax savings over several future years. Some accountants and financial advisors refer to capital loss carry forwards as a ‘tax savings account’ since you can dip into it at any time to lower your tax exposure for a given year.
The takeaway: You can lower your capital gains tax bill by carrying over your losses from prior years and using them wisely.
Give to Charity
About half of Americans donate to charities including religious institutions, disaster recovery, environmental causes, and higher education. Many people don’t realize that you can donate long-term appreciated assets, including stocks, to charities, which can significantly reduce your capital gains taxes and provide a range of other benefits.
When you donate long-term appreciated assets, you don’t have to pay any capital gains on the transfer and you can take an income tax deduction for the full fair market value up to 30 percent of your adjusted gross income. You can even use advanced strategies, such as “bunching” your contributions in a single tax year using donor-advised funds.
The takeaway: You can lower your capital gains tax bill by donating shares to charity and taking the tax break.
The Bottom Line
We all pay taxes on income and investments, but there are many ways to reduce that tax burden. While deductions and credits are popular strategies for ordinary income tax, capital gains taxes have their own set of strategies. The five techniques discussed above can help reduce your capital gains tax bill in the current year and even in future years.
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