Everyone likes to make money, but no one likes to pay tax. Unfortunately (or not, depending on your point of view) that’s how our system works. When you make a profit or capital gain on your investment you will pay tax on those gains eventually.
But that doesn’t have to be the case.
Before we get into the details, let’s get some of the terminology out of the way. In my last post you learned what cost basis was and why it mattered to your investment portfolio. In this post you will learn about capital gains and how to avoid paying tax on them.
The term “capital gains” simply refers to the gain or profit you make on your investment. If your cost basis on a stock is $10 and you sell it for $50, your capital gain or profit is $40. This $40 gain may be taxable.
Capital gains on stocks and mutual funds are generally taxed at a rate of 15% for most taxpayers unless your income falls into the highest tax bracket where your capital gains tax rate is 20%. Higher income taxpayers may also be subject to an additional 3.8% Medicare surtax on capital gains bringing your total tax to as much as 23.8%.
For a detailed explanation of the Medicare surtax you may want to read this previous blog post. The Charles Schwab website offers a quick summary of the various tax brackets and tax rates. You can look up your tax bracket by clicking here.
Below are 5 easy ways to avoid taxes on your investments
Stay in the 10% or 15% tax bracket. Married taxpayers with taxable incomes below $75,300 pay no tax on their capital gains. For singles, the 15% bracket is capped off at $37,650.
That may not sound like much income, but remember we are talking about taxable income. This is the amount of income you actually pay Federal income tax on. It is net of your adjusted gross income less your standard or itemized deductions, IRA contributions, personal exemptions and other items that lower your taxable income.
When you tally it all up a married couple could easily earn over $100,000 in a year and still fall into the 15% Federal income tax bracket. If that describes you, capital gains taxes are a non-issue. You will pay no tax on the gains of your investments as long as you are in the 15% tax bracket (or lower) in the tax year during which you sold your investment.
I will address getting into and staying in the 15% tax bracket in a future post. For now, just know that if you fall into the 10% or 15% Federal income tax bracket, you will owe $0 on the capital gains of your investments.
Contribute to a Roth IRA. Selling a stock or mutual fund that has experienced significant capital gains in a Roth IRA will also result in $0 tax as long as you follow a few basic rules.
Since Roth IRAs are funded with after tax dollars you don’t get a tax deduction on contributions made to these accounts. But your investment in a Roth IRA grows tax-deferred and comes out of the account income tax and penalty free if you have owned the IRA for more than 5 years and are over age 59 ½ . A stock with a cost basis of $10 that is later sold for $50 or even $500 will result in $0 tax in a Roth IRA, regardless of your income or tax bracket.
Roth IRAs have some limitations however. For one thing, you must have earned income to be able to contribute to a Roth IRA, and if your 2016 adjusted gross income exceeds $184,000 for married taxpayers ($117,000 for singles), you may not be able to contribute to a Roth IRA this year.
Roth IRAs contributions are also limited to $5,500 per year per individual, plus a catch-up contribution of $1,000 if you are age 50 or older. For example, a married couple with earned income below $184,000 could contribute up to $6,500 each to Roth IRAs. If you make much more than that, you won’t be able to contribute to a Roth IRA.
Sell investments with losses. You pay tax on your net capital gains. If you have investments with losses, you can sell them in the same tax year as you sell your investments with gains. The losses are subtracted from the gains to give you a net amount of capital gains that will be taxable, if any.
For example, if you sell a mutual fund with a $10,000 loss, this loss will offset up to $10,000 of capital gains on other stocks or mutual funds you sell during that same tax year.
Selling an investment just because it has a capital loss isn’t always a good idea, but in those cases where it makes sense to do so selling your poorest performing investments may provide an opportunity to take some tax-free gains on other more profitable investments.
Buy and hold. If you don’t want to pay tax on highly appreciated stocks and mutual funds, don’t sell them. Capital gains taxes are due only when you actually sell an investment for a profit. This is the difference between realized and unrealized capital gains.
That stock that you bought for $10 but now is worth $50? Your capital gains are realized and taxable only in the tax year during which when you sell that stock. The same rule applies for mutual funds and other types of appreciated investments. If you don’t sell, you won’t owe any tax. Minimizing trading activity and purchasing investments you buy and hold for the long term can reduce the amount you pay in capital gains tax leaving you with more money in your portfolio to continue to grow over time.
In fact, if you die owning a highly appreciated stock or mutual fund, all the gains will pass tax-free to your heirs. This is because your heirs will receive a “step-up in basis” when they inherit the stock – no matter the amount of the gain. This new, stepped-up cost basis is the value of your shares as of the date of your death. After you die, your heirs may pay capital gains taxes based on the new stepped-up cost basis of their shares when they sell them. If they are in the 15% tax bracket or lower or if the stock loses value after you die, it’s possible that they may never pay tax on these assets.
Donate your shares. Donating highly appreciated assets to your favorite non-profit is one of the most effective ways to make a charitable gift. No capital gains tax is due on shares of stock or mutual funds you donate to qualified 501(c)3 organizations.
When you donate a stock or mutual fund to charity the IRS allows you to write off the value of that asset against your ordinary, taxable income. A $10,000 donation becomes a $10,000 tax deduction. If your donation happens to be highly appreciated stock that you bought years ago, the capital gain is avoided as well.
Later this year when you are about to write a check to your church or charity, consider donating appreciated stock or mutual fund assets instead. You will get the same deduction on your tax return and also avoid any capital gains taxes due on your stock. The worst thing you can do is sell the stock first and then write a check for the proceeds to your favorite charity. This creates the exact taxable event you are trying to avoid.
That’s 5 easy ways to avoid paying capital gains taxes on your stock or mutual fund investments. Not every strategy will work for everyone and many of these ideas have some drawbacks. To determine the best tax strategy for your situation, please be sure to discuss these ideas with your financial advisor or tax professional.