You have probably heard quite a bit about taxes on stocks as a beginner investor. If you’re new to filing your taxes on your own and new to investing, combining the complications of the two can feel overwhelming. For example, did you know that the IRS has the power to charge capital gains taxes on any profits made from selling stocks?
Luckily, some strategies can help reduce the amount of tax you owe. One way is by taking advantage of Section 1031 Exchanges. This allows investments in real estate property to be exchanged for other types of assets without paying any federal income tax. However, both properties need to be held at least one year before the sale takes place.
Another way is through using tax-loss harvesting to sell off investments at a loss to offset gains you've made. In short, you’ve got options. And, we’re here to walk you through some strategies that can help you reduce the capital gains tax you pay when investing.
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How to Reduce Capital Gains Taxes on Stock Investments
Let’s start off by clarifying what a capital gains tax is. Basically, capital gains taxes are sent your way whenever you sell stocks for more than you paid to purchase them. Essentially, if you make a profit, you’ll be taxed.
The capital gains are classified into long-term and short-term gains. Long-term capital gains are on shares that you’ve held for at least a year. In this case, you’d be taxed at the long-term capital gains tax rate (which is lower). Short-term capital gains are on shares that you’ve held for less than a year. With these, you’ll be taxed at your ordinary income tax rate as if it were regular profit.
Now, let’s dig into how you can reduce the taxes you’ll pay on the gains we know you’re gonna be earning.
1. Take Advantage of Tax Loss Harvesting
Have you accrued capital gains for twelve months? If you have, then you should check to also see whether other investments have yielded capital losses. This is referred to as tax loss harvesting. And, that might just sound like a bunch of complicated words, but it's really not.
The basic idea behind tax loss harvesting is to sell an investment in a down market, and then buy it back after the price has recovered. You get the benefit of taking some losses for your investments, and you don't have to pay any capital gains taxes on them either because they are offset by the profits from buying back in at a higher cost basis.
The most common time for people to do this is at the end of every year before they file their taxes. Why? By then, they will know how much money they will owe the government and might want to offset as many losses as possible by taking advantage of capital gains rates. It’s also important to note that
You should consult a financial advisor or CPA if you are unsure about whether or not tax loss harvesting is right for you. Make sure it makes sense both short-term and long-term.
2. Pay Into Tax-Advantaged Accounts
If you really want to reduce the taxes you owe on your investments then we recommend that you optimize the amount of money you’re paying into your retirement accounts. Likewise, the stocks that are held in those tax-advantaged accounts like an IRA are not subject to capital gains taxes in the year that they’re realized.
For example, if you have a Traditional IRA account, any gains you have will be added to the overall account balance and you won’t be liable to pay those until you withdraw the money in retirement. If you have a Roth IRA account, the tax advantages are even better. As long as you meet certain conditions, you can withdraw the cash tax-free.
3. Make Charitable Contributions
When you pass down investment options to your children or grandchildren after their value has appreciated, you will be passing onto them a cost to pay the accumulated capital gains taxes they have earned over the years, too. You can lessen the capital gains tax burden through donating investments whose value has been appreciated highly to charitable institutions.
This is possible when your recurrent expenses do not depend on asset liquidation to be covered. By making an asset contribution to charity directly instead of cash, you qualify for a tax deduction as you get to deviate from paying the capital gains taxes.
Another option similar to this would be to give appreciated assets to family members who are in lower tax brackets. They would pay less compared to when the investment is in your ownership.
4. Spread Out Your Capital Gains
Another way to reduce capital gains taxes on your investments is to assess the cost-benefit analysis of holding on to assets and spreading the sale over a while, say three years. This eases the tax burden as you’re able to spread out any possible capital gains over an extended period of time, thereby reducing your overall gains incrementally.
Here's an example. You might sell a portion of a high-value investment at the end of the year 2022. Then, you'd sell another portion in 2023 and then complete the final part at the start of 2024.
However, be wary of the dangers and risks involved in holding stocks and waiting for them to appreciate. You’re essentially risking being left with losses instead of reaping benefits of immediate gains from selling right now.
5. Reinvest in the Opportunity Fund
The Tax Cuts and Jobs Act passed back in 2017 allows investors to enjoy certain tax benefits. Those should be valid through at least 2026. For example, you might be able to reap the benefits of reductions on capital gains taxes when you reinvest your capital gains in businesses that are located in an “opportunity zone.”
To enjoy these tax benefits, you’ll have to invest in a qualified opportunity fund. This is a private fund structured as a corporation or partnership. The business has to invest at least 90% of its capital into an opportunity zone. Technically, you’d be investing in anything from property or equipment to a business where 50% or more of income is derived from an opportunity zone.
Learn More With Wealth Stack
Here at Wealth Stack, we take the responsibility seriously. We walk our investors through the multiple available options on reducing the capital gains tax. We want to work to make sure that you’re informed. And, we want you to understand the best options for you and your investing journey.
Download the Wealth Stack app today to start learning how to invest like a pro. Then, invest straight from the app!