Capital gains result when shares of a stock are sold for more than you paid for them. The tax on these gains depends on how long the shares were held. The gain will be either short-term or long-term:
• Short-term capital gains: Capital gains on stocks that are held for less than one year are taxed at your ordinary income tax rate. There is no different treatment for tax purposes.
• Long-term capital gains: If the shares are held for at least one year, the capital gain is considered to be long-term. This means the gain is taxed at the long-term capital gains tax rates, which are lower than the ordinary income tax rates for many investors at 0%, 15%, or 20% depending on your filing status and adjusted gross income (AGI).
In addition to these rates, there is an additional capital gains tax for higher-income investors called the net investment income tax rate. This rule adds 3.8% to the capital gains tax for investors over certain income thresholds.
Proper tax planning can help manage your tax liability as it relates to capital gains. Here are some ways to minimize or avoid the capital gains taxes on stocks.
• Consider your tax bracket - Realizing capital gains can push you into a higher overall tax bracket. If you are close to the upper end of your regular income tax bracket, it may be wise to defer selling stocks until a later time or to consider bunching some deductions into the current year. This would keep those earnings from being taxed at a higher rate.
• Harvest your tax losses - Intentionally sells stocks, mutual funds, ETFs, or other securities held in a taxable investment account at a loss. Capital losses are used to offset capital gains. Any excess losses of either type are used to offset additional capital gains first. Then, to the extent that your losses exceed your gains for the year, up to $3,000 may be used to offset other taxable income. Additional losses can be carried over to use in subsequent tax years.
• Be mindful of the wash sale rule when using tax-loss harvesting, which states that an investor cannot purchase shares of an identical or substantially identical security 30 days before or within 30 days after selling a stock or other security for a loss. Essentially this creates a 61-day window around the date of the sale. Violating the wash sale rule would eliminate your ability to use the tax loss against capital gains or other income for that year.
• Donate stock to charity - You will not be liable for taxes on any capital gains due to the increased value of the shares. The market value of the shares on the day they are donated to the charity can be used as a tax deduction if you are eligible to itemize deductions on your tax return.
• Utilize a tax advantaged retirement account - If stocks are held in a tax-advantaged retirement account, any capital gains from the sale of stocks in the account will not be subject to capital gains taxes in the year the capital gains are realized.
• In the case of a traditional IRA account, the gains will simply go into the overall account balance that won’t be subject to taxes until withdrawal in retirement.
• In the case of a Roth IRA, the capital gains will be part of the account balance that can be withdrawn tax-free as long as certain conditions are met. This tax-free growth is one reason many people opt for a Roth IRA.
• Once money is in your 401(k), and as long as the money remains in the account, you pay no taxes on investment growth, interest, dividends or investment gains.
• Buy and hold qualified small business stock - If the stock qualifies under IRS section 1202 as qualified small business stock, up to $10 million in capital gains may be excluded from your income. Depending on when the shares were acquired, between 50% and 100% of your capital gains may not be subject to taxes.
• Reinvest in an Opportunity Fund – Under the Tax Cuts and Jobs Act of 2017, investors who take their capital gains and reinvest them into real estate or businesses located in an opportunity zone can defer or reduce the taxes on these reinvested capital gains. The IRS allows the deferral of these gains through December 31, 2026, unless the investment in the opportunity zone is sold before that date. An opportunity zone is an economically distressed area that offers preferential tax treatment to investors under the Opportunity Act. Click here for more information on Opportunity Funds and how they work.
• Hold until death - If you hold your stocks until your death, you will never have to pay any capital gains taxes during your lifetime. In some cases, your heirs may also be exempt from capital gains taxes due to the ability to claim a step-up in the cost basis of inherited stock. A step-up in basis means adjusting the cost basis to the current value of the investment as of the owner’s date of death. For investments that have appreciated in value, this can eliminate some or all of the capital gains taxes that would have been incurred based on the investment’s original cost basis. For highly appreciated stocks, this can eliminate capital gains should your heirs decide to sell the stocks, potentially saving them a lot in taxes.