6 Smart Strategies to Reduce Capital Gains Taxes on Investment Returns
Capital gains taxes can eat into your investment returns, but with the right strategies, you can reduce your tax liability and preserve more of your wealth. Here are six effective ways to manage and lower your capital gains taxes:
1. Hold Investments for More Than One Year
The IRS imposes higher tax rates on short-term capital gains, which apply to assets sold within a year of purchase. These gains are taxed as ordinary income, with rates ranging from 10% to 37%. To reduce your tax liability, consider holding investments for more than a year. When you hold assets for over a year, any gains are taxed at the more favorable long-term capital gains rates, which range from 0% to 20%, depending on your income.
However, certain assets such as collectibles or qualified small business stock are subject to a maximum long-term capital gains tax rate of 28%, and real estate may have additional tax considerations.
2. Bequeath Appreciated Assets to Benefit from Step-Up in Cost Basis
If you’re planning to transfer appreciated assets to family members, it may be more tax-efficient to hold on to them and pass them on upon your death. When you bequeath appreciated assets, they receive a step-up in cost basis, meaning their value is reset to the market price at the time of inheritance.
For example, if you bought an asset for $100,000 that appreciated to $250,000, you would owe taxes on the $150,000 gain if you sold it. But if you pass it on, your beneficiary will inherit it at the new $250,000 cost basis. This reduces the capital gains tax burden when they sell the asset later, even if they sell it shortly after inheritance.
3. Time Capital Gains Harvesting for Maximum Tax Efficiency
The timing of realizing gains can have a significant impact on your taxes. If you realize gains in years when your taxable income is lower, you’ll pay less in taxes. You can also spread out the realization of gains over multiple years to avoid pushing yourself into a higher tax bracket.
For instance, if you expect a significant income in one year, it might make sense to delay realizing large gains until you have a lower-income year. Alternatively, if you have gains that could trigger additional taxes, such as the Net Investment Income Tax (NIIT), consider realizing the gains gradually over multiple years to stay below the surtax threshold.
4. Use Tax-Loss Harvesting to Offset Gains
Tax-loss harvesting involves selling investments at a loss to offset capital gains from other investments. For example, if you have a $50,000 loss in one investment and a $40,000 gain in another, the loss can offset the gain, effectively reducing your capital gains tax liability.
Moreover, if your losses exceed your gains, you can use up to $3,000 of the remaining losses to offset ordinary income. Losses exceeding $3,000 can be carried forward to offset future gains or income.
By strategically realizing losses, you can reduce your taxable income and lower your overall tax burden. However, you’ll want to avoid selling assets you plan to keep long-term unless they no longer align with your investment goals.
5. Donate Appreciated Assets to Charity
Donating appreciated assets directly to a qualified charitable organization allows you to avoid capital gains taxes and receive a charitable deduction based on the asset’s fair market value. This is a great way to reduce your taxable income while supporting causes you care about.
For instance, if you have an asset that has appreciated significantly, donating it to charity means you won’t pay capital gains taxes on the appreciation. You’ll also be able to deduct the full value of the donation from your taxable income, which can reduce your overall tax liability.
Additionally, charitable trusts and donor-advised funds offer additional tax benefits and can help you structure your charitable giving for long-term financial planning.
6. Prioritize Tax-Efficient Accounts
One of the best ways to reduce your capital gains taxes is to hold assets in tax-advantaged accounts like IRAs, 401(k)s, or 529 plans. These accounts allow investments to grow tax-free, and withdrawals (depending on the account type) are either taxed at a favorable rate or not at all.
By holding appreciated assets in tax-advantaged accounts, you can defer capital gains taxes until you withdraw the funds. For example, in a traditional IRA, earnings grow tax-deferred, and you only pay taxes when you make withdrawals. Just be mindful of the withdrawal rules and penalties for early distributions.
In taxable accounts, it’s also wise to avoid assets that generate high tax liabilities, such as actively managed funds that frequently buy and sell securities, triggering short-term capital gains taxed at higher rates.
Conclusion
Reducing capital gains taxes requires thoughtful planning and strategy. By holding investments longer, timing your gains wisely, utilizing tax-loss harvesting, donating appreciated assets, and prioritizing tax-advantaged accounts, you can significantly reduce your tax burden. Consulting with a wealth management professional is key to ensuring that these strategies align with your long-term financial goals and investment strategy.
