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. That 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.
Check out our capital gains tax calculator.
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
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
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 since it can put you in a lower bracket for both income and capital gains taxes.
If you’re changing jobs, for example, or you’ve recently been laid off, this could be a great time to cash in high-value stocks. The same can be true if you’re nearing retirement and you’re expecting your income to go down once you stop working.
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.
If you’re leery about crunching the numbers on your own, you can always hire an advisor to help you. Many financial advisors offer tax minimization services. A matching tool like SmartAsset’s makes it easier to find an advisor who meets your needs. First you’ll answer a series of questions about your financial situation and goals. Then the program will pair you with up to three suitable advisors in your area. You can then read the advisors’ profiles and interview them before deciding who to work with.
Photo credit: ©iStock.com/DragonImages, ©iStock.com/menonsstocks, ©iStock.com/PeopleImages