How to Reduce Capital Gains Tax On Stocks
There are several ways your investments create taxable income—including interest, dividends, and capital gains.
The profits you make from selling your stocks can be a huge factor in your capital gains taxes and income tax.
Making money is great. but understanding how to reduce capital gains tax on stocks will be an important step to keeping your wealth.
Many investors seek to control their capital gains liabilities so as not to increase their tax burden.
Today, we’ll evaluate a few strategies that may help you avoid paying heavy rates when selling your stocks, and filing your tax return.
Here‘s how to reduce capital gains tax on stocks. If you want to know how the capital gains tax is calculated, go here.
Control Your Asset Location
To start, let's give a quick refresh on capital gains tax.
Capital gains tax is a specific type of federal tax incurred on the sale of the investment. There are two types:
Short-term capital gains tax
Long-term capital gains tax
If you hold an investment for less than a year, your investments will be taxed at short-term capital gains rates, which end up being the same as ordinary income tax rates.
But holding assets can come with significant tax benefits. By holding an asset for a year or more, you qualify for long-term capital gains tax rates, which are much more favorable (and often lower rates), either 0%, 15%, or 20% depending on your income for the year.
Now, let's begin to look at how taxpayers can mitigate them. The first and most critical part of mitigating capital gains (and ordinary income) tax is to ensure your assets are in the right accounts. This strategy is known as asset location or putting different securities in the most tax-efficient accounts for that particular investment.
Tax-advantaged accounts, both pre-tax and Roth, like 401(k)s, IRAs, HSAs, and other retirement accounts, are powerful tools for shielding your investments from capital gains taxes and lowering your taxable income— but you don't want your entire portfolio squirreled away within them. Given that each type of tax-advantaged account has contribution limits, you may not be able to put your entire savings into them anyway.
Whatever the case, you’ll likely hold some of your investments in a taxable brokerage account. With your savings split between taxable and tax-advantaged accounts, you should be mindful of which assets are in each account type.
Where Should You House Your Securities?
So, where should you start?
You’ll want to evaluate the tax efficiency of your investments.
A good rule of thumb is to use tax-advantaged accounts for more actively traded positions or less tax-efficient investments and direct your more tax-efficient and non-U.S. investments into taxable brokerage accounts.
Best Practice #1: Keep High Return Investments In Tax-Exempt Accounts
You should generally hold investments with the highest expected returns in Roth IRAs and HSAs. That’s because you can withdraw money from these accounts tax-free, so all that growth won’t drive up your tax bill in future years.
Best Practice #2: Investments With Short-Term Capital Gains Are Often Best In Tax-Deferred Accounts
If you hold active mutual funds, bonds, or engage in active stock trading, it’s often best to keep these investments in tax-deferred accounts like traditional IRAs.
These investments are more likely to create short-term capital gains that are taxed as income. Since distributions from tax-deferred accounts are taxed as income anyway, you aren’t really giving anything up, but you won’t be taxed along the way.
Best Practice #3: Stable, Tax-Efficient Investments Work Well In Taxable Accounts
And lastly, try to hold your most tax-efficient investments in your taxable brokerage account.
Index stock funds and stocks that you do not plan to trade frequently are great examples.
Taxable brokerage accounts have a distinct advantage: shares receive a step up on the cost basis when you pass, meaning the gain will be reduced, and your heirs will keep more of their value. As a result, you may be able to transfer more after-tax money to your heirs.<