If you’re an investor, or planning to be one soon, capital gains tax is an important topic. Though it offers substantial benefits over ordinary tax levels, you will still want to minimize the amount of tax that you owe, since it will represent a reduction in your overall return on investment.
What is Capital Gains Tax?
Capital gains tax is a tax levied by the government on appreciated assets. These are investments that rise in value, as opposed to those that are held primarily for the purpose of generating a regular income.
The tax is assessed on the difference between what you pay for an asset and what you ultimately sell it for. Let’s say you purchase a certain stock for $10,000. Two years later, you sell it for $15,000. The difference between the sales price and your acquisition cost – or $5,000 – is considered to be a capital gain.
Gains on assets held for less than one year are considered short-term gains, and taxed your regular tax rate. But gains on assets held for more than one year are generally taxed at lower rates.
For example, if a couple files married filing jointly, and earns less than $72,500, there will be zero tax on any long-term capital gains. If they earn more than $72,500, their long-term capital gains will be taxed at no more than 20%.
This is a major advantage considering that the highest level of federal taxation can be as much as 39.6%.
What Types of Investments Does the Tax Apply To
Capital gains tax will apply to just about any asset that you sell at a higher price than you bought it. The most typical assets that trigger capital gains taxes include the following:
This can include gold, silver, and platinum, whether it is held in bullion or in coin form.
Real estate produces some of the largest capital gains most people will ever see in their lifetimes. The capital gain on real estate is not only the difference between what you pay for it and what you sell it for, but can also be increased if it is investment property on which you take depreciation (the depreciation expense will lower your cost basis in the property, and increase your gain on sale).
This isn’t typically an issue on a personal residence. The IRS allows you a one-time exemption on the gain on the sale of a personal residence of up to $250,000 for an individual, or up to $500,000 for married filing jointly.
Stocks are probably the most common generators of capital gains tax liability. They can occur either on individual stocks you own and sell, as well as mutual funds, which also typically produce capital gains, even if you don’t sell any shares in the fund.
5 Ways to Beat Paying Capital Gains Taxes
Even though capital gains taxes are lower than ordinary tax rates, you can still look at ways to legally minimize them, or avoid them completely.
1. Charitable Donations
If you have stocks that have a substantial gain, you can donate them to a charity and avoid having to pay the capital gains tax. You’ll get the full charitable deduction on the value of the stock today, but not have to pay capital gains tax. You can contribute appreciated stock worth as much as 30% of your just gross income, without incurring the tax.
This will represent a substantial tax advantage over selling the stock at a taxable gain, then giving cash to the charity.
2. Opening a 529 College Savings plan
One of the primary reasons for investing for capital gains is to save money for your children’s college education. But if you set up a 529 college savings plan, investments held in the plan will appreciate without resulting in capital gains tax. It’s a way to have tax-free growth for the purpose of educating your children.
3. Harvest Capital Losses
Capital losses can be used to offset capital gains in any tax year. If your capital gains will be substantial, take a look at your portfolio, and see if there are stocks and funds that you can sell that will generate offsetting losses, reducing both your capital gains, and your capital gains tax.
4. Gift to Family Members in a Lower Tax Bracket
In much the same way that you might donate appreciated stock to a charity, you can also gift it to lower income family members. You can gift up to $14,000 per person per year, and assets with substantial gains will not be taxable to you.
However, the person you are gifting the assets to will have an acquisition basis of the asset based its value as of the date of the gift.
Translation: neither of you is subject to immediate capital gains tax.
5. Setup a Roth IRA
Assets held primarily for capital appreciation should be in a Roth IRA – or any other type of tax sheltered investment plan for that matter. The assets can increase in value – and even sold at substantial profits – and they will not be taxable until you withdraw the money at a much later date.
There’s an even bigger advantage with a Roth IRA. As long as you are at least 59 ½ years old, and your plan has been in existence for at least five years, there will be no tax on the withdrawals at all. That means no capital gains tax either.
Learn why a gold ira is actually better then having a roth ira from a tax standpoint. Learn more