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The end of the year is an excellent time to revisit your tax strategies with an eye toward ensuring you’re taking any and all actions needed to reduce your tax bill — before it’s too late. One area to look at is capital gains. Rising value is a good thing, but, if you sell an investment, be aware that the gains are potentially taxable. This means that, depending on the kind of asset it is, your tax bill might increase along with the proceeds of the investment sale. But with proper planning, you can reduce your capital gains tax liability — and avoid unpleasant surprises.
Holding periods and tax rates
Realized capital gains on assets held in taxable accounts will be taxed at either the short- or long-term capital gains rate, depending on how long you owned the assets before you sold them. If you held an investment for one year or less, your gains will be taxed at the short-term rate, which is your marginal income tax rate. For the 2019 tax year, these rates range from 10% to 37%.
Capital gains on assets held longer than one year are taxed at the long-term capital gains rate. Generally, investors whose annual income puts them in the 10% or 12% ordinary-income tax bracket are subject to the 0% long-term capital gains rate — up until the point where capital gains “fill up” the gap between their taxable income and the top of the 0% bracket.
Investors whose income puts them in the middle federal tax brackets for ordinary income generally pay the 15% long-term gains rate. But beware that the top 20% long-term gains rate kicks in before the top ordinary-income rate of 37% does. The 20% rate applies to married joint filers with a taxable income of more than $488,850 or single filers with a taxable income of more than $434,550. (The 37% ordinary-income rate thresholds are $612,350 and $510,300, respectively.) Keep in mind that you also may be subject to the net investment income tax (NIIT), as discussed later.
If capital gains tax is a concern for you, here are some ways to reduce your potential liability:
Monitor your holding periods. Given the fact that short-term gains are taxed more heavily than long-term gains, the first step in managing your tax liability is to pay close attention to your holding periods. Before you sell a security, check to see if you’re close to the point of qualifying for long-term status. If so, it may make sense to delay the sale.
Harvest tax losses. You can use capital losses to offset capital gains as well as ordinary earned income. For example, if you incurred a long-term capital gain of $5,000 and a long-term capital loss of $9,000, your net would be a long-term loss of $4,000. You can apply up to $3,000 of this loss each year against your ordinary income, which reduces your income tax liability. The remaining $1,000 can be carried forward to offset future capital gains and/or income. Be aware of any wash sale implications, however.
Use caution with year-end fund purchases. Many mutual funds distribute annual capital gains (and dividends) in December. Shareholders are taxed on these distributions, so you can reduce your tax exposure by waiting until after the capital gains and dividends have been distributed to invest in a fund.
Watch out for the NIIT. Taxpayers with modified adjusted gross income (MAGI) over $200,000 per year ($250,000 for married couples filing jointly and $125,000 for married couples filing separately) are subject to this extra 3.8% tax on the lesser of their net investment income or the amount by which their MAGI exceeds the applicable threshold. Many of the strategies that can help save or defer income tax on investments can also help avoid or defer NIIT liability, such as using unrealized losses to absorb gains. And because the threshold for the NIIT is based on MAGI, strategies that reduce MAGI — such as making retirement plan contributions — could also help avoid or reduce NIIT liability.
Timing isn’t everything
Timing your investment purchases and sales to reduce your capital gains tax, though important, is merely one aspect of what should be a multifaceted and wide-ranging strategy. A professional advisor can help ensure your strategic decisions are the right ones for you.