How to Avoid Capital Gains Tax
[SmartAsset, iStock Photo]
We all know that only two things in life are truly certain: death and taxes. But just because taxes are an inevitable part of our society doesn’t mean you can’t limit how much you pay to Uncle Sam. Taxes on capital gains can eat up a significant portion of your earnings each year. Here are some common strategies for avoiding capital gains taxes and how you can implement them. It’s wise to consult a financial advisor about how to minimize other taxes, besides capital gains.
What Are Capital Gains Taxes?
When you own an investment or other asset – such as real estate, land, a business or stocks, for example – and later sell that asset for a profit, you have realized capital gains. The tax that is then levied on the profit portion of your sale is called capital gains tax.
Depending on how your gains are classified, and your total taxable income for the year, your capital gains tax rate can vary. This percentage could be as low as 0% or as high as your ordinary tax rate.
How to Avoid Capital Gains Taxes
Handing over a chunk of your profit can be painful. Thankfully, there are a few ways that you can reduce the amount of capital gains taxes you will pay after selling an asset.
Choose Long-Term Investments
Capital gains can be classified as either short-term or long-term, each of which has its own tax rates.
Assets that you have held for less than a year are considered short-term. When it comes to earning short-term gains, expect to be taxed at your ordinary tax rate … which can be as high as 37%, depending on your total taxable income.
If you want to avoid that, you should choose long-term investments instead. By holding an investment for a year or more, you will qualify for long-term capital gains tax rates.
Most long-term capital gains will see a tax rate of no more than 15%, though certain assets (like coins and art) can be taxed at a rate up to 28%. Depending on your income, you may even qualify for capital gains tax rates as low as 0%.
Take Advantage of Tax-Deferred Retirement Plans
Your retirement accounts likely make up a bulk of your savings and future assets. It’s wise to optimize these as best you can by utilizing tax-deferred (and tax-exempt) plans, to save yourself from added capital gains taxes. When contributing to a tax-deferred retirement plan, such as a 401(k) or traditional IRA, you’ll receive a tax deduction on your contributions in the current tax year. This can save you money on your income taxes today, as well as help you to save even more toward the future.
Your money will also continue to grow over time. When you’re finally ready to sell your investments and withdraw, any growth in the account is taxed at your ordinary income rate, rather than being subject to capital gains like other investment accounts.
A tax-exempt account, such as a Roth IRA, doesn’t offer any tax benefits today. However, the money held in this account will grow tax-free until retirement. When you’re ready to use the money, your funds (and growth) can also be withdrawn tax-free, helping you avoid capital gains yet again.
Offset Your Gains
If you hold a number of different assets, you may be able to offset some of your gains with any applicable losses, allowing you to avoid a portion of your capital gains taxes.
For instance, if you have one investment that is down by $3,000 and another that is up by $5,000, selling both will help you reduce your gains. You would only be subject to capital gains taxes on the difference – or $2,000 – rather than the full $5,000 gain of the second investment.
Another offset strategy is tax-loss harvesting. With this method, you can carry over losses from one tax year into the next, to help offset future gains. Tax loss harvesting only applies if your losses in a given year exceed your total gains.
The Bottom Line
Reducing the capital gains taxes you pay on certain assets can keep more of your money in your own pocket. Capital gains taxes can range from 0% to 28%, depending on factors such as your income and the asset itself. Offsets, tax-advantaged retirement accounts and long-term investments may each be worth considering when developing a strong tax strategy.
Tips on Taxes
- Consider working with a financial advisor to ensure that you’re not paying a penny more than you need so. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Income in America is taxed by the federal government, most state governments and many local governments. The federal income tax system is progressive, so the rate of taxation increases as income increases. Use our free income tax calculator to get a quick estimate of what you owe.
By Stephanie Colestock