Investing in the stock market can result in greater returns than keeping money in a bank account. However, you may be exposed to higher taxes with these increased earnings. There are a number of ways for your investments to generate taxable income, such as interest, dividends, and capital gains. The proceeds from the sale of your stocks might significantly impact your capital gains taxes and income taxes.
There are numerous techniques to prevent or minimize paying capital gains tax on the selling of stocks. You can reduce your capital gains tax by holding your assets for longer periods, utilizing tax-deferred accounts, donating your equities to charity, and offsetting your profits with losses.
What Are Capital Gains Taxes?
When you sell an investment or other items, such as a home, piece of land, a business, or shares of stock, and earn a profit, you have realized capital gains. The tax imposed on the profit component of your transaction is referred to as capital gains tax.
Your capital gains tax rate can vary depending on how your gains are categorized and your total taxable income for the year. This proportion may be as low as zero percent or as high as your standard tax rate.
That gain is taxable in one of two ways:
Gains on investments held for less than a year qualify as short-term capital gains.
Long-term capital gains are profits made on investments held for more than one year.
Gains on short-term investments are taxed as ordinary income at the standard income tax rates. Depending on your income, long-term capital gains are taxed at either 0%, 15%, or 20%. The lower your income, the lower your tax rate on long-term capital gains.
How Are Capital Gains Calculated?
A capital gain is determined by subtracting the purchase price from an asset’s selling price. Therefore, if you purchased a stock for $1,000 and sold it for $2,000, you would realize a $1,000 capital gain. You must pay tax on this capital gain of $1,000 during the tax year in which you sold the asset.
Put simply: Capital Gain equals Selling Price minus Purchase Price.
Note that capital gains are only subject to tax when they are realized or sold. If you keep this stock rather than sell it, you have what is known as an unrealized capital gain, and no tax is required on the gain until the asset is sold.
The tax rate applicable to capital gains is dependent on the asset’s holding period. If you hold a stock for a year or more, the gain will be taxed at the rate applicable to long-term capital gains. However, if you keep equity for less than a year before selling it, the gain will be taxed at your regular income tax rate.
Short-Term Capital Gains Tax Vs. Long-Term Capital Gains
For tax purposes, capital gains on the sale of shares have been divided into two groups to allow for differential taxation of individuals who invest for the purpose of protecting their savings and those who invest for the purpose of generating income. Capital gains derived from the sale of stocks held for more than a year are categorized as long-term gains, and capital gains derived from the sale of shares held for less than a year are considered short-term.
Taxation On Short Term Capital Gains
Long-term investors, who invest their savings, enjoy a few more advantages than short-term investors. The capital gains of short-term investors are taxed at a fixed rate of 15%.
To reduce your tax liability on capital gains, however, you may deduct any expenses incurred during the acquisition or sale of the shares, such as commissions. Therefore, the tax calculation for short-term capital gains would be:
Selling Price – Buying Price of the Stock – Expenses on Purchase or Sale
15% of this equation calculating capital gains will be subject to taxation.
However, long-term investors are taxed differently on capital gains realized on the sale of their shares.
Taxation on Long-Term Capital Gains When You Sell Your Stock
Prior to 2018, long-term capital gains were exempt from any taxation. Any stock or equity held for more than a year may be sold for a profit free of taxation. This action was taken to promote cash liquidity in the markets so as to increase national wealth. However, the 2018 budget took a different approach and chose to tax long-term capital gains as well, levying a 10% tax on capital gains generated from investments held for more than a year.
However, the notion of goodwill in long-term investments remains intact, and as a result, long-term investors have been granted various exemptions to avoid long-term capital gains tax.
Will Capital Gains Tax Rates Change For 2022?
In 2022, the capital gains tax rates remain the same as in 2021: 0%, 15%, or 20%, depending on your income. The rate increases as a person’s income increases. While tax rates remain the same in 2022, the income thresholds for each tax band increase to account for inflation. The maximum amount of zero-rate taxable income is $83,350 for joint filers and surviving spouses, $55,800 for heads of household, and $41,675 for married filers filing separately.
Giving up a portion of your earnings might be hard. Fortunately, there are a few strategies to lower the amount of capital gains tax you must pay upon the sale of an asset.
Choose Long-Term Investments
Short-term and long-term capital gains are taxed at different rates.
Short-term investments are those that you have held for less than a year. Expect to pay your standard tax rate, which, depending on your total taxable income, maybe as high as 37%, on any short-term gains you make.
Long-term investments are the way to go if you want to avoid them. The owner is eligible for long-term capital gains tax rates when an investment is held for a year or more.
The long-term capital gains tax rate can be taken advantage of by holding taxable assets for a period of one year or longer. Even though the top marginal tax rate and the top rate for capital gains both fluctuate over time, the top rate for regular income is often higher than the top rate for capital gains. Therefore, from a tax perspective, it is normally preferable to attempt to hang onto taxable assets for at least a year if at all possible.
The maximum tax rate that can be applied to long-term capital gains is 28%. However, this only applies to rare and valuable items (such as coins and art). In some cases, taxpayers can pay no capital gains tax at all, depending on their income level.
Take Advantage of Tax-Deferred Retirement Plans
Your retirement funds likely represent the majority of your future savings and assets. It is prudent to utilize tax-deferred (and tax-exempt) plans to the fullest extent possible to avoid further capital gains taxes. You will receive a tax deduction on your contributions to a tax-deferred retirement plan, such as a 401(k) or traditional IRA, for the current tax year. This can save you money on your current income taxes and help you save much more in the future.
Your funds will also increase in value over time. Any earnings in the account are taxed at your regular income rate rather than the lower capital gains rate that applies to other investment accounts when you withdraw the money.
There are currently no tax benefits to using a tax-free account, such as a Roth IRA. Until retirement, however, the funds in this account will grow tax-free. When you’re ready to use the funds, they can be withdrawn tax-free, allowing you to avoid capital gains once more.
Offset Your Gains
If you own a variety of assets, you may be able to offset a portion of your profits against any eligible losses, allowing you to defer a portion of your capital gains taxes.
For example, if one investment is down $3,000 and another is up $5,000, selling both will assist minimize your earnings. Instead of paying taxes on the full $5,000 gain from the second investment, you’d pay taxes on the difference, or $2,000.
Tax loss harvesting is a further method of offsetting income. This strategy allows you to carry over losses from one tax year to the next in order to offset future gains. Tax loss harvesting only occurs if your losses exceed your income in a particular year.
Invest in an Opportunity Zone
The Tax Cuts and Jobs Act included “opportunity zones” that provide investors with favorable tax treatment. By investing in eligible low-income and troubled regions, you can delay taxes and possibly avoid stock capital gains tax entirely. Unrealized gains from the sale of shares must be invested in a qualified opportunity fund within 180 days of the sale and must be held for at least ten years to qualify.
Donate appreciated investments to charity
Donating to charity any investments whose value has increased since the time they were acquired. You will obtain a tax deduction for the fair market value of the investment on the date of the donation and will not be required to pay capital gains tax on the donated investments.
Gift Assets to a Family Member
If you don’t want to pay 15% or 20% in capital gains taxes, pass the appreciated assets to a person who is subject to a lower rate. The IRS permits taxpayers to make gifts of up to $16,000 per individual and $32,000 per married couple each year without submitting a gift tax return.
This allows you to give valued shares or other investments to a relative in a lower tax bracket. If the relative sells the asset, it will be taxed at their rate, not yours. In rare instances, capital gains tax could be completely avoided.
This is an excellent method for avoiding capital gains tax when leaving financial support or presenting to family members. Notably, this strategy does not work effectively when gifting to youngsters or students under 24 years old. These dependents must pay the same tax rates as their parents if they have unearned income from any source over $2,200, including capital gains and interest income. This so-called “Kiddie Tax” means that any tax advantages are typically negated upon the sale of the asset.
Lower Your Tax Bracket
When your income is lower, you may be eligible for 0% tax rates on long-term capital gains. You can reduce your taxable income by using withdrawals strategically. For instance, retirees can make withdrawals from a Roth IRA rather than a 401(k) or standard IRA because Roth withdrawals are not taxable in retirement. You can also optimize your deductions by paying your property taxes in full by December 31 or by making a single donation to charity in lieu of multiple smaller ones. Deferring income and maximizing deductions are two other methods to avoid being pushed into a higher tax rate. In addition to reducing your taxable income, maximizing your workplace retirement plans and health savings accounts (HSA) is a smart strategy.
Taking capital gains in different years
Jonathon McLaughlin, the financial strategist at Bank of America, recommends discussing with your tax advisor the possibility of “spreading the sale over numerous tax years – this can assist alleviate the impact.”
McLaughlin argues that you may sell a portion of a strong-performing investment at the end of 2022, another amount during 2023, and the remaining half at the beginning of 2024, so completing the transaction in a little over a year while spreading any capital gains over three tax years.
However, keep in mind that waiting to sell includes dangers. McLaughlin emphasizes that the benefits of holding on to these assets may not outweigh the benefits of selling now and reaping the gains, despite the higher tax burden.
Move to a Tax-Friendly State
Moving to a tax-friendly state may allow you to avoid capital gains tax on stocks while paying state income taxes, even though your place of residence has no bearing on your federal tax liability. There is no tax on profits in nine states, and the U.S. states of Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming are included.
Why Is There No Capital Gains Tax?
In addition to tax loss harvesting, there are two primary techniques to qualify for 0% capital gains tax:
Possibility Zones Take your capital gains and reinvest them in a Qualified Opportunity Fund within 180 days. You will be required to retain the funds for ten years, but there will be no capital gains on the fund’s earnings at the conclusion of that period.
10% to 12% tax bracket. This includes singles earning less than $40,400 and couples earning less than $80,800 in 2021. “Even if your taxable income is often too high to harvest gains tax-free, there may be years… when you can take advantage of this method,” explains Kiplinger. This includes those who have been briefly unemployed, those who are self-employed but have a variable income, and those who are nearing or have reached retirement age.
The issue of capital gains tax is not limited to the wealthy. Using a couple of these tactics, ordinary taxpayers can quickly save thousands of dollars in capital gains taxes. Especially if you’ve held assets for less than a year, capital gains taxes might negatively influence your investment returns. Investors can utilize a variety of ways to decrease or avoid capital gains tax on stocks, bonds, and other assets. Consult a financial planner or tax counselor before taking any action to discuss your present circumstances and the options you are contemplating.
Do I owe taxes on holdings that I do not sell?
Unless the shares are sold, there will be no capital gains tax to pay. If you keep the stock until you die, your heirs will inherit it and may or may not have to pay inheritance taxes. While you remain the owner of the stock, you will be subject to income tax on any dividends received.
How long must stock be held to avoid paying capital gains tax?
If you sell shares of stock for more than you paid for them, regardless of how long you have owned them, you will be subject to capital gains tax. The gains will be considered short-term if you’ve owned the shares for less than a year. The shares will be regarded long-term if you’ve owned them for at least a year. Most taxpayers benefit from paying long-term capital gains taxes since the rates are lower than short-term capital gains taxes.
What are the capital gains tax brackets?
Gains on short-term investments are added to annual income and taxed at conventional rates ranging from 10% to 37%. Long-term capital gains are taxed separately and are not included in your income. However, your taxable income determines whether your long-term capital gains are taxed at zero percent, fifteen percent, or twenty percent.
How many shares of stock may you sell tax-free?
In 2022, if your filing status is single and your total income is less than $40,400, you will not owe any long-term capital gains tax. The tax-free threshold for long-term capital gains for married couples filing jointly is $80,800.