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Minimize Capital Gains Taxes

Investing can yield big returns, but it comes with a price. When you sell off investments and realize a profit, Uncle Sam expects you to pay taxes on your earnings. These are called capital gains, and they come in long- and short-term variations. These could mean a much bigger tax bill if you’ve had a successful investing year. Fortunately, there are some specific strategies you can use to minimize what you owe on your capital gains. A financial advisor can also help you with capital gains taxes.

1. Follow the One-Year Rule

Capital gains tax can either be short-term or long-term, depending on how long you own an investment before you sell it. The short-term capital gains tax rate is the same as your regular income tax rate. If you’re in one of the top tax brackets, your capital gains tax burden can be particularly high.

Once you get past the one-year mark, however, you can take the long-term capital gains rate if you decide to sell. The long-term capital gains rate maxes out at 20%, which is much lower than 39.6% (the top rate for short-term capital gains). If you can hold off on selling, you can reduce your capital gains taxes.

2. Look for Ways to Trim Your Income

Minimize Capital Gains Taxes

Your capital gains rate depends on your taxable income and the lower that number is, the less tax you’ll pay. The best way to bring down your taxable income is to take advantage of every deduction you’re eligible for.

You can start by maxing out your contributions to tax-advantaged retirement accounts. Funneling money into a 401(k) reduces the portion of your income that’s subject to taxes. IRA and charitable contributions, business expenses, mortgage interest and medical expenses are just some of the other things you can score deductions for.

3. Harvest Your Losses

If you’ve got some stocks or mutual funds that have turned out to be duds, you can use them to your advantage to balance out capital gains. Tax loss harvesting involves selling off investments that aren’t performing well and replacing them with similar investments. This strategy can cancel out your gains and cut down your tax bill.

One guideline to keep in mind is that short-term and long-term losses have to go toward offsetting gains of the same type. You can ignore this rule, however, if your losses exceed the type of gains you’re trying to cancel out. For instance, if you have $10,000 in long-term losses but only $5,000 in long-term gains you could use the difference toward your short-term gains.

4. Time Sales Carefully

Minimize Capital Gains Taxes

One final way to minimize the amount of capital gains tax you owe is to sell strategically. Specifically, you want to wait until your income takes a dip to unload your most profitable investments. This can be particularly effective if you’re selling short-term holdings. That’s because it can put you in a lower bracket for both income and capital gains taxes.

If you’re changing jobs, for example, this could be a great time to cash in high-value stocks. The same can be true if you’re nearing retirement and expecting your income to go down.

Bottom Line

Avoiding a high capital gains tax bill isn’t as difficult as you might think. The key is to have a plan that minimizes the amount you have to pay. Knowing how to crunch the numbers to your advantage can help you hang on to more of your returns. When in doubt, try to hold as long as you can. If you can manage to sell most of your investments under long-term capital gains tax rates, you’ll receive much more favorable treatment from the IRS.

Investing Tips

  • If you have specific questions about how capital gains taxes can affect your long-term investment returns, consider speaking with a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Capital gains taxes are inevitable, but you can minimize your investment fees. Online brokerages are a great place to start looking.

Photo credit: ©iStock.com/SrdjanPav, ©iStock.com/PeopleImages, ©iStock.com/skynesher

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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