4 Ways to Avoid Getting Hurt by Capital Gains Taxes
You might think it's too early in the year to start worrying about taxes, but the truth is that as an investor, it pays to always have taxes on your mind. That's because the right moves could shield a chunk of your investment gains from the IRS or save you a major tax headache down the line. Here are just a few strategies you should know about.
1. Hold investments for at least a year and a day
The length of time you retain investments in your portfolio before selling them can impact your associated tax implications. Investments held for a year or less, and then sold at a profit, are subject to short-term capital gains taxes, whose rates mimic those of ordinary income. Now under the recent tax changes, most individual brackets were lowered so that this year, you'll pay less on your highest dollars of income than last year. But you'll still pay higher taxes on short-term gains than you will on long-term gains.
Long-term capital gains apply to investments held for at least a year and a day, and their associated tax rates are much lower than what you'll pay for short-term gains. For example, under the new tax system, top earners pay 37% on ordinary income and short-term gains. Taxes on long-term gains, on the other hand, max out at 20%, and that's just for the highest earners out there. Most taxpayers will be subject to a 15% rate on long-term gains, and lower earners pay 0%.
2. Use losses to offset gains
If you have a loser investment in your portfolio, unloading it could end up being a smart tax move. That's because the losses you take on investments can be used to offset gains. That means if you have a year where you're looking at $5,000 in gains, and you take a $5,000 loss, the two will cancel each other out, thus eliminating your tax liability on those gains.
Furthermore, if your net investment losses for the year exceed your gains, you can use the remainder to offset your ordinary income, up to the $3,000 mark. And if you still have a net loss after that, you can carry it to future tax years. So say you're looking at a $10,000 loss and a $5,000 gain in the same year. The first $5,000 of your loss will cancel out your gains, the next $3,000 will be used to offset ordinary income, and the final $2,000 will be carried to the following tax year.
3. Pay estimated taxes on your gains
Most people associate estimated taxes with freelancers and the self-employed. But if you have a year where you're taking in a fair amount of money in capital gains, then it might make sense to pay estimated taxes on those gains quarterly, as opposed to waiting until you file your tax return.
Why part with your money sooner? The only reason has to do with avoiding an underpayment penalty. If, come tax season, you find that you've underpaid your taxes by, say, a few hundred dollars, it's not a big deal. But if you come to find that you've underpaid by thousands of dollars, you could get hit with an IRS penalty. Along these lines, paying taxes along the way could help you avoid unpleasant surprises when you file your return. Namely, you won't risk not having the money to pay your tax bill if it's larger than anticipated.
4. Avoid wash sales
We just learned that it sometimes makes sense to sell investments at a loss and reap the associated tax benefits. But what if you want to buy back one of the investments you sold shortly thereafter, either because it's started to recover or you need it for diversification purposes? If that's the case, then you'll to be careful of what's known as the wash sale rule.
A wash sale occurs when you sell an investment and then buy back the same one, or one that's virtually identical, within 30 days. Once that happens, you can no longer write off your associated losses from the initial sale. The good news is that avoiding wash sales is generally pretty easy -- just don't sell a stock and buy the same one back. You can, however, sell one biotech stock at a loss, buy a different biotech stock within 30 days, and still claim the loss. Similarly, you can sell an energy stock at a loss and then buy an energy exchange-traded fund (ETF) later that week without losing out on the tax benefits.
Avoiding problems with capital gains taxes generally boils down to selling investments strategically and reading up on the rules. Play your cards, and you'll pocket more of those gains in the coming year.
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