Stocks and mutual funds are taxed by way of capital gains -- which are generally lower than ordinary income tax, but there are nuances you should understand in order to avoid them or be opportunistic about them. Capital gains taxes can apply to any other property that acquires value over time. These taxes are calculated by subtracting the cost of the investment from the final selling price of said investment. This final amount is reported as capital gains. But, the final amount can be taxed at different rates depending on the investment type and the total monetary gain.
Below, we’re reviewing how capital gains taxes are determined and what methods you can use to reduce them.
Capital Gains Tax Rates
The total tax amount will depend on a variety of factors, though the IRS taxes most individuals at a rate of zero to 15 percent.
Here are a few factors that determine capital gains tax rates:1
- A total income of less than $83,350 (if married filing jointly) is set at zero percent. Keep in mind that this range will change depending on your filing status.
- A rate of 15 percent is set if your income is between $83,350 and $517,200 (if married filing jointly).
- A rate of 20 percent applies to the extent that your taxable income exceeds $517,200 (if married filing jointly).
- Rates higher than 20 percent result from certain investment types, such as collectibles.
Make sure to check with the IRS to understand how different investments are taxed.
Duration of the Investment
The amount of time you hold an investment can reduce the amount of taxes you ultimately pay. The IRS has established two investment types: short-term and long-term. Investment duration is calculated from the date of purchase to the date of sale. Over a year is considered long-term, while short-term is under a year.1
What Isn’t Affected by Capital Gains?
Certain types of property and accounts are not affected by capital gains taxes. If applicable, see if you can utilize these property and account types to maximize your investments.
Two general property types are unaffected by capital gains. The first is business property, including products. The second is anything you create as an individual. This could be a book you wrote or an invention you patented.
Alternatively, specific retirement and education accounts, such as a Roth IRA, can help protect your investments from capital gains taxes.
Offsetting Capital Gains
Investments may not always pay off. Sometimes, a market change results in your property going down in value. This reduction is also calculated on your taxes and is calculated into your capital gains taxes. This can lower your taxable income range.
For example, if you receive $100,000 from selling one investment, you would be taxed in the 15 percent range. However, if you lost $25,000 on another investment, this would drop your total income from investments to $75,000, which could place you beneath the 15 percent tax range. These reductions and gains can only be combined if they are the same type of investment, long-term or short-term and are sold in the same year.2
Some investors may want to consider Direct Indexing as a way to harvest capital tax losses. Between Two Fiduciaries -- OnTrack Wealth Management's video series -- discusses the merits of Direct Indexing in greater depth for those readers who are interested in learning more.
Mutual Fund Capital Gain Distributions
If you own a mutual funds outside of a retirement account (i.e., 401k, 403b, IRA, Roth IRA, etc.) you may have experienced the unpalatable taste of a capital gain distribution that negatively impacted your taxes. By design, mutual funds must pass all taxes onto their shareholders, and when a fund buys and sells stocks and bonds within the fund, there may be capital gains. Hence, you may be liable to pay those capital gains even when you have chosen not to sell any of your mutual fund shares. Worst yet, in some years, shareholders will see Net Asset Value or NAV of the mutual fund decrease and still receive a capital gain distribution. How is this? Often, poor markets will motivate more shareholders to sell, or redeem shares as it is is with a mutual fund. When these redemptions take place and there are capital gains within the positions owned by the fund, those capital gains are distributed to all shareholders. Around the beginning of October, mutual fund companies will publish anticipated capital gain distributions. This gives a sneak peak into the impending tax damage and provides shareholders with an opportunity to avoid the capital gain distributions by selling some or all of their shares. For free advice on this subject, please CONTACT US HERE.
With very few exceptions, OnTrack Wealth Management does not recommend mutual funds because of the tax inefficiencies of the fund described above. Exchange Traded Funds or ETFs are a better solution that are typically lower in fees, high in diversification, and even provide active management if that is desired.
Capital gains taxes can be postponed by using the income to invest in a similar property type.3 However, make sure to consult the IRS website or your tax professional before moving forward on any like-kind exchange, as the requirements and investment types have changed over the years.
Make sure you prepare to protect your investments from higher tax rates. And when selling an investment or even a piece of property, make sure to consult a financial advisor or IRS representative to help determine how much you could be taxed.