By Chris Palabe, CFS®, AIF®
As we watch the market go up and down (and then up again), we rarely think about the taxes we might pay with the rise of our portfolio or home value. It’s important to have a healthy, diversified portfolio, but it’s also important to consider capital gains taxes and how they play a role in your overall strategy.
How much you pay in capital gains taxes depends on how long you hold your investments. Having an investment for a year or less will trigger short-term capital gains taxes, which are taxed as ordinary income, as high as 37% in some cases. (1) Long-term capital gains taxes are based on your income and are taxed at 0%, 15%, and 20%. (2) While the simplest way to pay lower capital gains taxes is to hold your assets for more than a year, there are other strategies to prevent taxes from eating away at your wealth.
Let’s look at four ways you can help minimize your capital gains tax liabilities.
Take Advantage of Tax-Deferred Saving Accounts
Saving for retirement is one way to avoid taxes on capital gains. With tax-deferred accounts (think IRAs and 401(k)s), you’ll only pay ordinary income tax when you withdraw the money, and you won’t face capital gains taxes on the growth. The same goes for Roth IRAs. Not only will you benefit from avoiding income taxes on the withdrawal if you are 59½ and have held the Roth for more than five years, but you’ll also avoid capital gains taxes.
Plan Out Your Gains & Losses
Not all your stock picks are going to provide growth, and there may be times when you have to make some tough decisions about your portfolio. Tax-loss harvesting is a strategy that allows you to offset your capital gains by capital losses. If you own a losing bond, mutual fund, or stock in accounts other than your 401(k) or IRA, review your realized and unrealized gains and losses. You might be able to offset some of your gains by selling some losses, thus lowering your taxable income. And if you live in a high-tax state, you may want to defer tax by deducting up to $3,000 of capital losses in excess of capital gains and carrying any leftover capital losses forward into future years. (3)
Cost basis is another piece of the capital gains tax puzzle to keep in mind. Cost basis is the amount you paid for your asset. There are many ways to decide what cost basis to use if you have multiple asset purchases in different periods. Most investors use the first-in, first-out method (FIFO), but there are other methods, such as last-in, first-out (LIFO) and average cost. Be sure to consult your financial advisor before taking advantage of this option.
Check the Tax Implications of Your Assets
If the asset in question is real estate, you may be in luck. Currently, homeowners can sell and exclude up to $250,000 (for single tax filers) or $500,000 (for those who are married filing jointly) of the gains if you owned the property and lived in the house for at least two of the five years prior to selling it. (4) Even better, you can claim this exclusion on another property in the future as long as it’s been more than two years since you previously claimed it.
Business profits are also excluded from capital gains tax and instead are subject to business tax rates. In general, capital gains taxes apply to the sale of personal assets. Your business income is reported differently on your tax return and won’t face capital gains taxes.
Understanding Capital Gains Taxes
Although there are many alternative strategies for those who want to offset or defer capital gains taxes or need to structure their income in a way that minimizes taxes, as with anything related to taxes, this can get complicated quickly. Luckily, you don’t have to figure it out alone.
We would love to talk to you further about your investments, their tax implications, and how you can structure your investments to be most advantageous for your goals. We invite you to schedule a 15-minute introductory phone call or call us at 847-249-6600 to learn if we are the right fit for your financial goals.
Chris Palabe is the founder and CEO of Palabe Wealth, a financial services firm providing retirement plan strategies for businesses and individuals. For 25 years, Chris has been serving his clients with customized plans and a boutique approach. He started his firm because of his passion for making a difference in others’ lives and a genuine desire to build long-term relationships with his clients so they can seek to achieve their ideal retirement and manage risk. Chris is a Certified Fund Specialist® (CFS®) and Accredited Investment Fiduciary® (AIF®) professional and has a degree from Université Denis Diderot (Paris VII). When he’s not working, you can usually find him riding horses and competing in dressage at a national level. He also loves reading, watching movies, and eating out. To learn more about Chris, connect with him on LinkedIn.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
This material was prepared for Palabe Wealth Inc.’s use.
No strategy assures success or protects against loss.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.