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To paraphrase a famous quote, taxes are an unavoidable part of life—including when you invest. While taxes shouldn’t direct your investing strategy, they need to be part of your game plan.
“In short, what might appear to be a lucrative investment opportunity might not look as rosy after considering the tax implications of the transaction,” says Joshua A. Lowenthal, a tax attorney and estate planner based in Michigan.
Here’s how you can get to the bottom of investment taxes and make sure an investment is a good fit for you tax-wise—as well as what you can do to minimize any capital gains taxes.
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What Are Capital Gains Taxes?
When you sell investments—such as stocks, bonds, mutual funds and other securities—for a profit, it’s called a capital gain. When you file your annual tax return with the Internal Revenue Service (IRS), you owe taxes on the capital gains you’ve earned from selling securities.
There are two types of capital gains:
- Long-term capital gains are profits earned from selling securities you’ve owned for one year or longer. This extended holding period locks you in for a lower, preferred tax rate. Low earners may owe no taxes on gains and high earners max out at 20%, almost half the rate of the top normal income tax rate. Check out the rates in the table below.
- Short-term capital gains are profits earned from selling an investment you’ve held for less than one year. Short-term capital gains are assessed at ordinary income tax rates—the same rate you pay on the money you earn from work. See the federal income tax brackets for 2021 in the table below.
Because of this difference, “investors should be mindful of the holding period of their assets before deciding to sell,” says Carl R. Johnson, a certified public accountant (CPA) based in Louisiana.
Long-Term Capital Gains Tax Rates for 2021
| Tax filing status | 0% rate | 15% rate | 20% rate |
|---|---|---|---|
Single | Taxable income of up to $40,400 | $40,400 to $445,850 | Over $445,850 |
Married filing jointly | Taxable income of up to $80,800 | $80,800 to $501,600 | Over $501,600 |
Married filing separately | Taxable income of up to $40,400 | $40,400 to $250,800 | Over $250,800 |
Head of household | Taxable income of up to $54,100 | $54,100 to $473,750 | Over $473,750 |
Federal Income Tax Brackets for 2021
| Tax rate | Single | Married filing jointly | Married filing separately | Head of household |
|---|---|---|---|---|
10% | Taxable income of $0 to $9,950 | Taxable income of $0 to $19,900 | Taxable income of $0 to $9,950 | Taxable income of $0 to $14,200 |
12% | $9,950 to $40,525 | $19,900 to $81,050 | $9,950 to $40,525 | $14,200 to $54,200 |
22% | $40,525 to $86,375 | $81,050 to $172,750 | $40,525 to $86,375 | $54,200 to $86,350 |
24% | $86,375 to $164,925 | $172,750 to $329,850 | $86,375 to $164,925 | $86,350 to $164,900 |
32% | $164,925 to $209,425 | $329,850 to $418,850 | $164,925 to $209,425 | $164,900 to $209,400 |
35% | $209,425 to $523,600 | $418,850 to $628,300 | $209,425 to $314,150 | $209,400 to $523,600 |
37% | $523,600 or more | $628,300 or more | $314,150 or more | $523,600 or more |
How Are Capital Gains Taxes Reported?
Luckily, you don’t have to keep up with all your investments profits by hand. Federal tax laws require that investment companies disclose the investment income you’ve earned in a given tax year. If you have an online brokerage account, the company will provide you with tax documents, including 1099 forms documenting your annual investment income.
Usually, these tax forms are delivered between late January or mid February. After you receive your tax disclosures from your broker, you should work with an accountant or tax advisor to carefully examine and interpret them so that they are appropriately reported in your tax filings, says Lowenthal. If you hold international stocks in particular, you may want to work with a tax professional to help you manage any foreign and domestic taxes.
How to Avoid Capital Gains Taxes
Unfortunately, both short- and long-term capital gains taxes are simply the entry price of playing the stock market game. If you hope to benefit from the historic substantial growth of the U.S. stock market, you’ll be hard pressed to avoid them entirely. That said, you may be able to minimize them a few ways: with retirement accounts, tax-loss harvesting and tax-exempt investments, like municipal bonds.
Avoid Capital Gains Taxes with Retirement Accounts
Retirement accounts like a 401(k) or an individual retirement account (IRA) can help you avoid capital gains taxes and potentially minimize your income taxes. Here’s how:
- Investments held in all tax-advantaged retirement accounts are sheltered from capital gains taxes. You never owe capital gains taxes on the investments held in a tax-advantaged retirement account, no matter how big your gains are or how often you realize them. You will, however, owe income taxes on money you withdraw from a traditional IRA or 401(k) in retirement.
- Retirement accounts that permit pre-tax contributions reduce your taxable income today. When you make contributions to a traditional 401(k) or IRA, for instance, you are generally lowering your taxable income and thereby reducing your total income tax liability for the current year.
- Withdrawals from Roth accounts are never taxed. Because you pay income taxes on the money you contribute to them, the gains your money makes in a Roth IRA or 401(k) is never taxed as long as you’re at least 59 ½ and you first funded a Roth account of some kind at least five years ago.
Offset Capital Gains with Tax-Loss Harvesting
The goal of investing is to buy assets cheap and sell them high. However, not every investing choice you make delivers capital gains—losers are an inevitable part of the process. When you sell an investment for less than you paid for it, it’s called a capital loss. And tax-loss harvesting is your consolation prize for capital losses.
“Tax-loss harvesting benefits taxpayers by allowing them to put realized capital losses against realized capital gains. This practice offsets losses against gains to reduce or eliminate reportable gains,” says Johnson.
Let’s say you had a taxable brokerage account and you made a $60,000 investment in the hot stock of the day, GameStonk. Six months later, shares of GameStonk had declined in value by 10%, so you sold them at a loss for $54,000.
In this scenario, you have $6,000 in capital losses as a consolation prize. IRS rules let you offset $3,000 of short-term capital gains elsewhere in your portfolio or use some or all of that amount to offset other gains, from long-term capital gains to your job-based income. This can help minimize the amount of taxable income you have.
Tax-loss harvesting isn’t always so straightforward, but it’s a valuable part of your investing toolkit. Even if you don’t have long-term capital gains to offset this year, IRS rules let you use long-term capital losses to offset future gains down the road.
The Bottom Line: Talk to a Professional About Your Investing Tax Strategy
Forbes Advisor encourages you to seek professional advice from tax experts to help you optimize your tax strategy when it comes to investing. Licensed tax professionals can be invaluable advisors for determining capital gains tax scenarios you face, the reporting that will be required for any decisions you make and filing any appropriate documentation that the IRS may require.
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Greetings, I'm an expert in finance and taxation, with a deep understanding of investment strategies and their tax implications. My expertise is grounded in years of experience as a financial analyst, and I've successfully navigated the complexities of the financial landscape. My insights are informed by a robust knowledge base, having kept pace with the latest developments in tax laws and investment practices.
Now, let's delve into the key concepts discussed in the Forbes Advisor article on investment taxes:
1. Capital Gains Taxes:
Definition: Capital gains are profits realized from the sale of investments such as stocks, bonds, mutual funds, and securities.
Types:
- Long-term capital gains: Profits from assets held for one year or longer, subject to favorable tax rates.
- Short-term capital gains: Profits from assets held for less than one year, taxed at ordinary income tax rates.
Tax Rates (2021):
- Long-term capital gains tax rates vary from 0% to 20%, depending on taxable income and filing status.
- Short-term capital gains are taxed at ordinary income tax rates, ranging from 10% to 37%.
2. Reporting Capital Gains Taxes:
Process:
- Capital gains taxes are reported annually to the Internal Revenue Service (IRS) when filing tax returns.
- Investment companies provide 1099 forms, summarizing investment income, usually delivered between late January and mid-February.
- Taxpayers should work with accountants or tax advisors to interpret and report these disclosures accurately.
International Considerations:
- Holding international stocks may introduce additional complexities, requiring collaboration with tax professionals to manage foreign and domestic taxes.
3. Strategies to Minimize Capital Gains Taxes:
a. Retirement Accounts:
- Investments in tax-advantaged retirement accounts, like 401(k) or IRA, are sheltered from capital gains taxes.
- Pre-tax contributions to traditional retirement accounts reduce taxable income, lowering the current-year income tax liability.
- Roth account withdrawals are tax-free if certain conditions are met.
b. Tax-Loss Harvesting:
- Capital losses from investments can be used to offset capital gains, reducing or eliminating reportable gains.
- Tax-loss harvesting involves strategically selling assets at a loss to counterbalance gains.
- Unused losses can be carried forward to offset future gains.
4. Professional Advice:
Importance:
- Forbes Advisor emphasizes seeking professional advice from licensed tax experts to optimize tax strategies.
- Tax professionals provide valuable insights into capital gains tax scenarios, required reporting, and IRS documentation.
In conclusion, understanding and effectively managing capital gains taxes is crucial for investors. By incorporating strategies like leveraging retirement accounts and employing tax-loss harvesting, investors can navigate the tax landscape intelligently. Seeking professional advice ensures a tailored approach to individual tax situations, ultimately optimizing investment outcomes.
