Capital gains taxes can erode investment returns.
Whether saving for retirement or a large purchase or planning to leave a legacy for your heirs, adopting tax-efficient investing strategies can significantly reduce your tax liability and help maximize wealth.
Here are actionable strategies to minimize capital gains taxes while maintaining a well-balanced portfolio.
Understand the basics of capital gains taxes
Capital gains taxes apply when you sell an asset for a profit. Your tax rate depends on how long you’ve held the asset and your income level.
- Short-term capital gains apply to assets held for one year or less and are taxed at ordinary income tax rates, which can be as high as 37%.
- Long-term capital gains: Assets held for more than one year qualify for lower tax rates, ranging from 0% to 20%, depending on your taxable income.
Here are the income thresholds that typically apply:
- 0% rate: For individuals with taxable income up to $47,025 (for tax year 2024) and couples filing jointly with income up to about $94,050.
- 15% rate: This rate applies to individuals with taxable income between $47,026 and $492,300 and to couples filing jointly with income between $89,251 and $518,900.
- 20% rate: For individuals with taxable income over $518,900 and couples filing jointly with income over $583,750.
These thresholds can vary slightly yearly due to inflation adjustments, so check current tax brackets.
In addition to federal taxes, some states impose capital gains taxes, which can further impact your returns. Understanding these distinctions is crucial for implementing strategies that minimize your tax exposure.
Strategic tax-loss harvesting
Tax-loss harvesting is a popular technique for offsetting capital gains by selling decreased-value investments. The loss can be used to offset gains from profitable sales, reducing your overall tax liability.
When managing investments for tax purposes, it’s essential to understand how capital gains and losses work. For instance, if you sell one stock and realize a profit of $10,000 while selling another stock at a loss of $5,000, the IRS allows you to offset the profit with the loss. As a result, your taxable gain would be $5,000 rather than the entire $10,000 profit.
Harvested losses can play a significant role in reducing your overall tax burden.
You can use these losses to offset up to $3,000 of your ordinary income each year. If your net capital losses exceed this limit, the remaining losses can be carried forward to future tax years, allowing you to continue utilizing them to offset gains or income.
We approach tax loss harvesting with caution due to the IRS wash-sale rule. This rule states that if you sell a security at a loss and then repurchase the same or substantially identical security within 30 days, you won’t be able to claim that loss on your taxes.
Tax-loss harvesting requires ongoing portfolio monitoring and timing, which can be challenging. Working with a financial advisor can help ensure you maximize this strategy while adhering to IRS rules.
Invest in tax-advantaged accounts
Tax-advantaged accounts, such as IRAs, 401(k)s, and Health Savings Accounts (HSAs), could offer significant tax benefits for certain investors, as their tax treatment is different than Capital Gains
- Traditional IRA accounts : Contributions are tax-deferred, and no capital gains taxes apply to investments within the account. The tax deductibility of contributions is limited based on certain income thresholds. Withdrawals are taxed as ordinary income.
- Roth accounts : Contributions are made with after-tax dollars, but qualified withdrawals, including investment gains, are tax-free in retirement. Roth eligibility is subject to income limitations.
- HSAs : These accounts offer a triple tax benefit: contributions are tax-deductible, growth is tax-free, and withdrawals for qualified medical expenses are tax-free.
Using these accounts strategically allows you to defer or eliminate capital gains taxes, depending on your financial goals and timeline. Long-term investors might prioritize Roth IRAs to maximize tax-free growth, while those looking for near-term medical savings may leverage HSAs.
Hold investments for the long term
One of the simplest ways to minimize capital gains taxes is to adopt a long-term investing approach. By holding assets for over a year, you qualify for the lower long-term capital gains tax rates.
This strategy also aligns with broader financial planning principles, such as reducing transaction costs, benefiting from compound growth, and avoiding emotional decisions that can undermine long-term goals.
An investor who frequently trades stocks might trigger multiple short-term capital gains events, incurring higher taxes. A buy-and-hold investor benefits from lower tax rates and compound growth, which can substantially increase wealth over time.
Gift appreciated assets
For investors with philanthropic goals or substantial estates, gifting appreciated assets can reduce capital gains taxes.
Donating appreciated securities to a qualified charity allows you to avoid paying capital gains taxes on the appreciation while receiving a charitable deduction for the asset’s fair market value.
You can gift appreciated assets to family members in lower tax brackets, transferring the tax liability at a reduced rate. Be aware of annual gift tax limits, which are $18,000 per recipient in 2024 or $36,000 for married couples.
Grandparents may gift appreciated stock to a grandchild, allowing the grandchild to sell the stock and pay a lower capital gains tax rate. This strategy can be particularly effective for families looking to reduce estate taxes while providing financial support to loved ones.
Leverage charitable trusts
Charitable trusts, like Charitable Remainder Trusts (CRTs), can effectively minimize capital gains taxes while supporting a cause you care about.
When you transfer appreciated assets to a CRT, the trust sells the assets without incurring capital gains taxes. As the donor, you receive an immediate charitable tax deduction based on the present value of the future charitable donation. You or your beneficiaries also receive income payments from the trust for a specified period.
This strategy benefits high-net-worth individuals seeking to reduce their tax burden and charities seeking long-term funding.
Other charitable giving strategies, such as Donor-Advised Funds (DAFs), can also be effective alternatives to CRTs.
DAFs allow donors to contribute assets to the fund, receive an immediate tax deduction, and then recommend grants to charities over time, offering flexibility in charitable giving.
This strategy particularly appeals to individuals who want to support multiple causes while enjoying tax advantages.
Other options include private foundations, charitable gift annuities, and direct donations, each with unique benefits and considerations for both the donor and the recipient organizations.
Use step-up in basis
The IRS provides a valuable tax benefit known as the step-up in basis for inherited assets. When you inherit an asset, its cost basis is adjusted to its fair market value at the original owner’s death date.
For example, if your parents purchased a stock for $50,000 worth $150,000 at their death, your cost basis becomes $150,000. If you sell the asset immediately, you owe no capital gains taxes.
This benefit highlights the importance of estate planning and choosing the right strategy to pass on wealth tax-efficiently.
Final thoughts
Minimizing capital gains taxes requires thoughtful planning and disciplined execution. By understanding the tax implications of your investment decisions and leveraging strategies like tax-loss harvesting, tax-advantaged accounts, and gifting, you can reduce your tax burden and keep more of your investment gains.
Partnering with a financial advisor can ensure you maximize these strategies while staying aligned with your financial goals. With their guidance, you can optimize your portfolio and navigate the complexities of tax-efficient investing.
