Example – Let’s say you’re single and you have $200,000 of taxable income for the year 2020. If you look at the chart you can see your last dollar earned will be taxed at 32%. The income tax rates are on a tiered scale opposed to a flat rate. Your effective tax rate which is pretty much the average tax rate will be slightly less than this, since every dollar is not taxed at 32%.
If you sell a stock for $50,000 and you have $20,000 for your cost basis you will have a capital gain of $30,000, which would be subject to capital gains tax. If you held this stock for less than a year you would be taxed at your ordinary income rate of roughly 32%. If you held this stock for more than a year it would be subject to long term capital gains rates and be taxed at 15%. For comparison purposes, that is roughly $9,600 vs. $4,500 in tax liability. That is a total difference of $5,100. As you can see, this is a significant difference and can be material amounts of money.
Ways to Minimize Capital Gains Taxes
Tax loss harvesting and tax gain harvesting occur when you sell an investment and buy a different one in its place. You are harvesting the losses or gains by intentionally selling the position and buying a different one thereby keeping the money invested. The goal is to take the tax hit now allowing you to take advantage of the lower capital gains rates. Capital losses can be used to offset future capital gains or be deducted against ordinary income up to $3,000. Capital losses can carry forward into future years. One thing to be mindful of when harvesting losses is that you cannot buy a substantially identical security or fund. This is defined by the IRS and if it is violated you will be subject to the wash sale rules, where the loss will be disallowed.
Reporting Capital Gains
Capital gains are reported on schedule-D of your tax return. Your custodian will provide you with a 1099 that shows your capital gains for the year. This information is to be used to complete your schedule-D which will flow to the front of your 1040 personal income tax return. It is very important to keep up with all records and proceeds from the sale of any assets that are subject to capital gains tax. These are common records and questions a CPA or tax preparer will ask of you.
Next Steps for You Can Take
To take advantage of preferential capital gains tax, you can begin by pulling a recent statement of your investment portfolio from your custodian. They will be tracking your cost basis and gains and losses. You can then determine what your income is likely to be for the year and if it could make sense to harvest any gains or losses. If you have a life event such as a job loss or are going back to school it can be a good time to review your finances with a professional, such as your financial advisor or CPA. They can help you make an informed decision about your investment portfolio.
If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER at Applied Capital. Email him at [email protected] or fill out a contact form.
This blog is provided for informational purposes only. Such views are subject to change at any point without notice. The information in the blog should not be considered investment or tax advice or a recommendation to buy or sell any types of securities. Some of our blogs or information therein have been obtained from third party sources believed to be reliable but such information is not guaranteed. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. No reliance should be placed on, and no guarantee should be assumed from, any such statements or forecasts when making any investment decision.