Investing

How To Avoid Capital Gains Tax – 5 Effective Strategies

Making money from an investment can be exciting. But before you start tallying up your investment gains, it’s important to think about taxes. In particular, most investment gains are subject to capital gains tax, which can eat significantly into your profits.

In some cases, you might be able to reduce or even avoid capital gains tax. If you’re interested to learn how to avoid capital gains tax, you’ve come to the right place. Let’s take a closer look at what capital gains tax is, when you have to pay it, and how you can avoid it in this guide!

Taxes

What is Capital Gains Tax?

Capital gains tax is a tax levied on investment profits by the federal government. If you sell a stock for a profit, that profit – also known as a capital gain – will be taxed and a cut of it will be paid to the US government.

Importantly, capital gains tax is separate from income tax. So investment income is subject to different tax rules than employment income. 

Capital Gains Tax

Short-term vs. Long-term Capital Gains Tax

There are two different types of capital gains: short-term capital gains and long-term capital gains.

A short-term capital gain is realized when you buy a stock and sell it for a profit less than one year later. If you buy that same stock and sell it for a profit over a year later, then that is considered a long-term capital gain. The defining difference is simply whether you held an asset for less than or greater than one year before realizing a profit from its sale.

Capital Gains Tax Rates

Understanding the difference between short-term and long-term capital gains is important because the two types of gains face different capital gains tax rates.

Short-term capital gains are taxed at your ordinary income tax rate. Depending on your income, this could be between 10% and 37%.

Long-term capital gains are taxed at a special rate that depends on your income. For a single filer making less than $40,400 per year, long-term capital gains are not taxed at all. For the same filer making between $40,400 and $445,850, long-term capital gains are taxed at 15%. Individuals making over $445,850 are taxed at a 20% rate.

The critical thing to note is that for any given individual, long-term capital gains are taxed at a much lower rate than short-term capital gains. This has been true for decades, even as the exact income brackets and tax rates have changed with each successive tax reform legislation.

When Do You Have to Pay Capital Gains Tax?

You have to pay capital gains anytime you realize a profit on an investment. Stocks, bonds, and other securities are subject to capital gains taxes when you buy and sell them for a gain. However, capital gains tax also applies to assets like jewelry, vehicles, collectibles, and even real estate – including your home.

Pay Capital Gains Tax

Note that some assets are exempt from capital gains tax. For example, copyrights, non-collectible antiques, and musical compositions can all be sold without paying capital gains tax.

You also only have to pay capital gains tax when you make a net profit across all of your investments. Say you buy 10 stocks and sell five a year later for a loss and the other five for a gain. You can offset your gains with your losses to get your net profit. Capital gains tax is assessed only on this net profit. If you have a net investment loss at the end of the year, you can even use that loss to offset future capital gains for tax purposes.

How to Avoid Capital Gains Tax

While it’s difficult to avoid capital gains tax entirely, there are some techniques you can use to reduce your tax bill.

However, before we dive into those techniques, it’s important to remember that the goal of investing is to make money, not to avoid taxes. In theory, you can avoid capital gains taxes by only losing money on your investments – but that won’t do your net worth much good. Always make the smartest possible investment decision first, and think about reducing your capital gains tax burden second.

Avoid Capital Gains Tax

With that in mind, let’s look at 5 ways that you can avoid capital gains tax.

Don’t Sell

One way to avoid capital gains tax is to simply hold your investments forever. If you don’t sell and realize a profit, you won’t be taxed.

Of course, this isn’t always practical or financially wise. But if you don’t need the money and can pass on your assets to your heirs, there are some tax benefits.

Inherited assets are always taxed at the long-term capital gains rate when they’re sold. In addition, the price of the asset at the time of your death is used as the cost basis for the inheritor. So, any unrealized gain accumulated between when you buy an asset and when you die is never subject to capital gains tax.

Tax Loss Harvesting

You can also avoid paying capital gains tax by offsetting your investment profits with losses. With this strategy, you can sell off an asset that has lost value and realize a loss that counts against your net profit for the year. Then you can purchase a similar asset to maintain your desired portfolio balance.

If you do use tax loss harvesting, make sure you understand the wash sale rule. After selling an asset like a stock, you cannot repurchase the same stock within 30 days and still claim a loss for tax purposes.

Hold Positions Longer

Even if you can’t entirely avoid capital gains tax, you can reduce your tax bill by ensuring that you are primarily realizing long-term gains instead of short-term gains. Look for investments that you can hold onto for at least a year. If you are considering selling an asset for a gain, consider whether it would make sense from an investing perspective to hold off for a few weeks or months.

Invest with an IRA

Investing gains realized inside a retirement account like an IRA or 401(k) are not subject to capital gains tax. This is true for both traditional and Roth accounts. So, you don’t have to worry about tax-loss harvesting or the difference between short- and long-term gains when trading with these accounts.

The downside is that there are rules about how much money you can contribute to a retirement account each year. In addition, you cannot withdraw funds without a penalty until you turn 59 ½.

Use a Different Cost Basis

If you purchase the same stock multiple times and sell your position in portions rather than all at once, you might be able to reduce your tax burden by changing your cost basis.

Most investors use a first in, first out cost basis, which means that your net profit is calculated based on the notion that the shares you bought first are the first ones you sold. However, you can also use a last in, first out basis to realize a short-term gain now and leave the first shares you purchased so that they can later be sold for a long-term gain.

Money

Conclusion: Avoiding Capital Gains Tax

Capital gains tax shouldn’t be your primary focus when investing, but it is worth keeping in mind. There are several techniques you can use to minimize or even completely avoid capital gains tax. When deciding which ones are right for you, be sure to consider how much you’re likely to pay in capital gains tax and whether these techniques work with your broader investment goals.

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Kevin

Kevin is an ambitious entrepreneur that is obsessed with all things related to finance. From a young age, Kevin has always been involved with side hustles ranging from online selling to freelance work. Over the years, Kevin graduated from side hustles and started launching multiple online and offline businesses. Kevin is a serial entrepreneur who loves starting new businesses and exploring all things related to business and finance. He is constantly looking for new ways to save money, invest money, and create income streams.

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