Capital gains optimization can allow you to build a tax-efficient investment strategy. Since understanding capital gains is one of the key building blocks of Financial Independence, we are taking a closer look at the concept today.
Capital gains come into play when you are investing in taxable accounts. Generally, capital gains occur when you sell an investment for more than you bought it for. They are taxed at special rates and if you play your cards right, that special rate can be zero!
Table Of Contents
- Important Terms
- What Are Capital Gains?
- Tax Implications Of Capital Gains
- What Are Capital Losses?
- How To Optimize Your Long Term Capital Gains
- Real Estate And Capital Gains
- Capital Gains Are Distinct From Dividends
- Don’t Forget About State Capital Gains
- The Bottom Line
Before we can define what capital gains are, let’s take a minute to define some of the important terms that you’ll encounter as you dive into the world of tax optimization.
Tax-advantaged accounts: These are retirement accounts where your contributions are tax-deductible. Instead of paying taxes on this money this year, you are waiting to pay taxes on these funds when you withdraw them in the future.
It is important to understand that when you do withdraw from your tax-advantaged accounts those withdrawals will classify as taxable income. A few examples include your 401(k), 403(b), or 457.
Roths: Roth vehicles, such as a Roth IRA or a Roth 401(k), are other types of accounts that you might be using to save for retirement. Contributions made to Roth vehicles are not tax-deductible, which means you will pay income taxes this year on that money.
However, when you withdraw the funds in the future, you will be able to do so without paying taxes.
Taxable accounts: Money in a taxable account is similar to money in your savings account. These accounts are not tax-advantaged in any way.The money in a taxable account is not bound by any rules of retirement ages or minimum distributions. You will have the flexibility to withdraw these funds at any point.
And it is in taxable accounts where capital gains become relevant.
Basis: At it’s simplest, your basis is the purchase price of the security and it is used in the calculation of capital gains. That equation is: sale price – basis = capital gain (or loss). There are some things you can do to manipulate the basis. Such as selling and repurchasing the security or in the case of real estate, taking depreciation.
Listen: A Capital Gains Case Study for 2020
What Are Capital Gains?
A capital gain is a rise in the value of a security over its purchase price. It is the difference between the current value and the purchase value, or the basis.
For example, let’s say you purchased a share of stock for $100 at some point in the past. If that share is worth $180 today then you have capital gains of $80.
However, you will only create a taxable event when you sell your shares and realize the capital gain. Until you sell the capital gains remain unrealized.
When you create a taxable event by selling your shares and realizing a capital gain, it may fall into one of two categories:
- Short Term Capital Gain: You will create a short term capital gain if you sell a security within one year of purchasing it.
- Long Term Capital Gain: You will create a long term capital gain if you sell your security after holding it for more than a year.
Tax Implications Of Capital Gains
The tax code favors investors that are able to realize long term capital gains.
Short term capital gains are taxed as ordinary income. That means that you’ll pay taxes on these funds based on your marginal tax rate.
Long term capital gains have significant tax advantages. Here are the tax brackets:
|Married Filing Jointly
|Head Of Household
|Married Filing Separately
What this table says is that if you are married filing jointly and you have less than $80,000 in taxable income, including your long term capital gains, you will pay 0% in long term capital gains taxes on the federal level.
Keep in mind, that’s taxable income–income after you’ve taken all your deductions. So if you consider the standard deduction of $24,800 you could have $104,800 in income in 2020 and still pay no capital gains taxes.
With these rules, you have the ability to potentially pay $0 in federal taxes on the income you need to cover your expenses in retirement. You need to be aware of the limitations of the tax brackets and work with multiple vehicles to create the most efficient drawdown strategy possible.
What Are Capital Losses?
A capital loss is the exact opposite of a capital gain. You’ll see a capital loss when the value of a security falls below its purchase price. The difference between the current value and the purchase price, or the basis, is the capital loss.
For example, let’s say that you purchased a share of stock for $50 at some point in the past. If that share is now worth $20, that creates a capital loss of $30.
Just like a capital gain, a capital loss will only become a taxable event when you sell your shares. At the point of sale, you create a taxable event on the realized losses. Until then, the capital loss will remain unrealized.
If you create a taxable event with a capital loss, then it will fall into two categories:
- Short Term Capital Loss:You will create a short term capital if you sell a security within one year of purchasing it.
- Long Term Capital Loss:You will create a long term capital loss if you sell a security after holding it for at least one year.
How To Optimize Your Long Term Capital Gains
Optimizing your long term capital gains is a useful strategy for those on the path to Financial Independence. Let’s take a closer look at two methods.
Stay Within The 0% Tax Bracket
One optimization strategy is to realize capital gains up to the limit of the 0% tax bracket. With this, you would be capital gain harvesting, which is a useful strategy for the FI community.
This strategy is making sure that you max out your capital gains right up the limit of the 0% tax bracket. If you don’t need the income to live on you can sell the securities, realize the capital gains, and then buy back similar securities at the higher price, therefore resetting your basis and reducing future capital gains.
If you are married filing jointly, you can realize up to $80,000 of capital gains in 2020 without paying any federal income tax. Remember, that limit does not include your deductions. With the standard deduction of $24,800, you could realize up to $104,800 of taxable income, which includes your long term capital gains, without paying a dollar in federal taxes.
What About The Wash Sale Rule? Beware: The Wash Sale Rule does not apply to Capital Gains Harvesting. In fact it’s the opposite you are asking the IRS to tax you and they are, but at a 0% tax rate. The Wash Sale Rule applies to Tax Loss Harvesting (see below for more information)
Offsetting Capital Gains With Capital Losses
Another strategy is to use your capital losses to offset your capital gains. If you have a net capital loss, then you can deduct that from other types of income. You are limited to offsetting up to $3,000 per year in ordinary income for federal tax purposes. However, you can carry over the remaining balance of your capital losses into future years.
Many investors practice tax-loss harvesting. This is where they sell when their investments are down in order to realize the capital loss. At that point, they use the realized losses to offset any realized capital gains. Generally, the investor will then repurchase similar securities. — Again, beware of the wash sale rule! The rule states you must wait 30 days before buying “substantially identical securities.” See the IRS explanation here.
For example, let’s say an investor owns 100 shares of a stock that they purchased two years ago for $75 each. Today those stocks are worth $65 each. Therefore, they have $1,000 of unrealized capital losses. They could sell those shares, realize their $1,000 in losses and then repurchase the shares at $65 each.
This gives them $1,000 in capital losses they can use to offset $1,000 in capital gains.
Since you can carry over your capital losses to deduct from your taxable income in future years, it can be a useful strategy.The goal of tax loss harvesting is to minimize your tax liabilities to allow your portfolio to continue working for you.
Real Estate And Capital Gains
Capital gains also apply to your real estate investments. Let’s take a closer look.
Capital Gains On Your Rental Properties
Real estate can also create capital gains. When you sell a rental property for more than you purchased it for, that will create a realized capital gain.
However, calculating capital gains on rental properties is trickier than on stocks. It’s not as simple as: sale price – purchase price = capital gain. If you’ve owned the property for more than a year then you’ve taken depreciation on the property. So the first thing you need to do is calculate your basis.
Real estate is depreciated over 27.5 years. This means you get to depreciate 1/27.5th of the purchase price every year and take this “expense” off your income. But while those depreciation expenses are great at reducing your income in that specific tax year, it’s also lowering your basis in the property.
For example, let’s say you bought a property for $100,000. $100,000 divided by 27.5 is $3,636. Each year you own the property you can claim $3,636 in depreciation expense and that amount comes off your income, saving you money on taxes. It also lowers your basis by that amount. So after the first year, your basis is no longer $100,000. It is now $96,364.
If you own this property for 10 years your basis will be $63,640. If you sell the property for $250,000 the capital gains would be $186,360 (250,000 – 63,640 = 186,360)
You need to factor this gain into your total capital gains for the year. The limitations of the tax bracket apply to all capital gains, so the sale of a rental property that has appreciated significantly could affect your tax strategy for the year.
Exclusion For Your Primary Residence
If you sell a primary residence that has grown in value since your purchase, the profit from the sale may be exempt from capital gain rules. You can exclude up to $250,000 from the gain on that income if you are single, or $500,000 if you are married filing jointly.
In order to qualify for the exclusion, you need to live in the home for at least 2 years within a 5 year period. It’s important to note that you are generally not able to qualify for this exclusion if you’ve excluded the gain of another home’s sale within the last two years.
Capital Gains Are Distinct From Dividends
When you are optimizing your investment portfolio, you will need to consider dividends in addition to capital gains and losses. The tax rules surrounding dividends may affect your strategy.
Don’t Forget About State Capital Gains
One last thing to remember when you are optimizing your capital gain tax strategy is to factor in your state taxes. The tax rules for capital gains will vary widely based on your particular state. Make sure to factor state taxes into your long term capital gains optimization strategy.
The Bottom Line
You don’t have to wait until retirement to start harvesting long term capital gains. If you and your spouse earn under the limit of $80,000, then you can start harvesting capital gains this year!
Once you understand the rules surrounding capital gain harvesting, you can optimize your retirement strategy to minimize your tax liabilities. It is easy to see how impactful the ability to save thousands of dollars in taxes could be to your retirement plan.
With the large potential impact, it is important to take advantage of tax-deferred retirement accounts whenever possible. If you are able to defer your higher marginal tax rates now, you could take control of your tax liabilities in the future by controlling your income based on the limitations surrounding the long term capital gain tax benefits.
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I'm an enthusiast and expert in financial strategies and tax optimization, and I've delved deeply into the concept of capital gains. My knowledge spans various aspects of investment, taxation, and retirement planning. Now, let's dive into the key concepts used in the article about capital gains optimization:
- Definition: Retirement accounts where contributions are tax-deductible, and taxes are deferred until withdrawals in the future.
- Examples: 401(k), 403(b), or 457 accounts.
Roths (Roth IRA, Roth 401(k)):
- Definition: Accounts where contributions are not tax-deductible, but withdrawals in the future are tax-free.
- Tax Treatment: Contributions are taxed in the year made, but earnings and withdrawals are tax-free.
- Definition: Accounts not offering tax advantages; capital gains in these accounts are subject to taxation.
- Features: No restrictions on withdrawal timing, no minimum distributions.
- Definition: The purchase price of a security, used in the calculation of capital gains or losses.
- Equation: Sale price - Basis = Capital gain (or loss).
- Manipulation: Basis can be manipulated, e.g., by selling and repurchasing a security.
- Definition: The increase in the value of a security over its purchase price.
- Taxable Event: Realized upon selling the investment.
- Categories: Short-term (sold within one year) and long-term (sold after holding for more than a year).
Tax Implications of Capital Gains:
- Short-term Capital Gains: Taxed as ordinary income based on marginal tax rates.
- Long-term Capital Gains: Taxed at special rates (0%, 15%, or 20%) based on income levels.
- Definition: Decrease in the value of a security below its purchase price.
- Taxable Event: Realized upon selling the investment.
- Categories: Short-term and long-term, similar to capital gains.
Optimizing Long-Term Capital Gains:
- Strategy 1: Stay within the 0% tax bracket for long-term capital gains.
- Strategy 2: Offset capital gains with capital losses; utilize tax-loss harvesting.
Real Estate and Capital Gains:
- Calculation: More complex than stocks; involves considering depreciation.
- Exclusion: Primary residence gains may be exempt (up to $250,000 for singles, $500,000 for couples).
- Distinct from Capital Gains: Tax rules surrounding dividends may affect overall investment strategy.
State Capital Gains:
- Reminder: Tax rules for capital gains vary by state; consider state taxes in the optimization strategy.
In conclusion, understanding these concepts is crucial for building a tax-efficient investment strategy, a key component of achieving Financial Independence. By optimizing capital gains, utilizing tax-advantaged accounts, and considering state-specific rules, one can significantly impact their long-term financial success.