You’ve held onto your investments for 20 years, watching them grow their value (with some ups & downs along the way!). Now, you’re ready to sell, but the thought of paying a hefty tax bill is daunting. Let’s explore some strategies to minimize your tax liability!
Note that “investments” is a broadly used term here, and could be individual stocks, a mutual fund, and/or ETFs, or more.
Understand capital gains tax: short and long term
When you sell appreciated investments, the profit is considered a capital gain. Capital gains have 2 flavors, so to speak, “long-term” and “short-term.” The difference? Well, it’s how long you’ve owned them! (Surprising, right?) If you’ve held the funds for more than a year, it’s a “long-term” capital gain, which is taxed at a lower rate than “short-term” gains.
The maximum federal tax rate on “long-term” capital gains is 20%, but most taxpayers will pay 15%, and some may even qualify for a 0% rate.
The federal tax rate for “short-term” capital gains is your regular income tax rate (so, you’re most likely in the 12-37% Federal tax bracket with current tax laws). Think of it this way, if you sell and “realize” a “short-term” gain, you’ll pay tax on that just like you had a side job that you pay income tax on.
Ideally you want to sell (“realize”) capital gains in the “long-term” rate, which again is 366 days or longer (1+year).
Use “Tax-Loss Harvesting” when markets are moving a lot
If you have other investments that are currently at a loss (so, they are worth less than you purchased them for), you can sell them to offset capital gains. This strategy, known as “tax-loss harvesting”, can help reduce your overall tax liability. This is best done with a trusted financial and tax advisor, and a good advisor should be proactively doing this with your brokerage accounts. Your advisor can help you understand the specific rules and regulations that apply to your situation and ensure that you're maximizing your tax benefits while minimizing your risk. Better yet, if your advisor manages your investments, they can do it for you!
Here’s how tax loss harvesting works:
- Sell at a Loss: If you have an investment that has decreased in value, you can sell it and realize a capital loss. This loss can be used to offset any capital gains you've made during the year.
- Purchase a Similar Investment: After selling the losing investment, you can repurchase a similar but not identical investment. This is important because the IRS has rules about "substantially similar" investments. If you buy something too similar, it may be considered a "wash sale" and you won't be able to claim the loss.
- Offset Capital Gains: The capital loss you realized from the sale can be used to offset any capital gains you've made on other investments. This can reduce your overall tax bill.
- Carry Forward Losses: If you have more capital losses than capital gains in a year, you can carry forward the excess losses to future years to offset future gains.
To reap the benefits of tax-loss harvesting, it's crucial to understand the IRS's definition of "substantially similar" investments. This generally refers to securities that are economically equivalent, such as stocks in the same company or similar ETFs tracking the same index.
To avoid a "wash sale," you must wait 30 days before repurchasing a substantially similar security. This waiting period ensures that your loss is recognized for tax purposes and can be used to offset gains.
Want some interesting reading to go along with this? Here’s the IRS’s website explaining it...https://www.irs.gov/publications/p550
Know Your Cost Basis
Your cost basis is the original value of your investment, or said normally, how much you paid for the investment out of your pocket, adjusted for any dividends reinvested and capital gains distributions. Accurate record-keeping is crucial here. The difference between your selling price and your cost basis is your capital gain (and what you’re going to be paying taxes on).
Note that most custodians (Schwab, Vanguard, Fidelity, etc.) keep very good records for you of your cost basis, so the following section you may skip. HOWEVER, if you purchased your funds before 2011, then you may need to head over to your file cabinet to find old statements.
I should throw it out here, if you have a financial advisor, she should be able help you to work with your custodian and get your cost basis correct, so you don’t need to do the laborious paperwork....
(in case you are interested, 2011 is the year when the IRS started requiring custodians to record and report cost basis information to the IRS and taxpayers)
If you need to calculate your cost basis (though like we said before, it’s unlikely you’ll need to do this), these are good steps to take:
- Gather Records: Collect all purchase records, including dates and amounts.
- Include Reinvested Dividends: Add the value of any reinvested dividends to your cost basis.
- Adjust for Splits: If your mutual fund has undergone any splits, adjust your cost basis accordingly.
Donate appreciated shares to your favorite charity
Consider donating your appreciated investments to a qualified charitable organization, such as a 501(c)(3) public charity. You can avoid paying capital gains tax on the appreciation, and you may also be able to claim a charitable deduction for the full market value of the shares. There are limits on this, typically 30% of your Adjusted Gross Income, so again, this is good to check with your trusted advisor on how much you can deduct. Your advisor can help you weigh strategies like Donor Advised Funds if you’re wanting to make a large gift in a single year.
Gift shares to family members
At a loss for holiday gifts? You can gift shares to family members who are in a lower tax bracket! They can sell the shares and potentially pay a lower tax rate on the gains.
Though this article is about financial advice and not social advice, be careful asking your family members how much money they make and their tax bracket. Sometimes people are real sensitive about that, especially if you happen to mention you’re wanting to gift the shares so you don’t need to pay as many taxes... :)
Outside of social faux pas, keep in mind annual gift tax rules and limits. This would be another example of where your financial advisor can help discuss gift tax rules.
While gifting appreciated shares to family members can be a strategic move, it's important to be aware of potential tax implications. If the recipient sells the shares shortly after receiving the gift, they may be subject to capital gains tax on the appreciated portion.
Spread Out the Sales
Instead of selling all your shares at once, consider spreading the sales over multiple years. Why? Because the U.S. federal government imposes capital gains taxes at various rates, with lower rates typically applied to long-term capital gains. By strategically spreading out the sale of your appreciated investments over multiple tax years, you may be able to keep your taxable income within a lower tax bracket.
This can help you stay in a lower tax bracket and reduce the overall tax impact. Working closely with tax professionals and advisors who do tax planning can help you sell the most amount of your investment while staying in the lower tax brackets.
Recognize the Unknown Unknowns
When it comes to selling appreciated investments, there are often unknown unknowns—factors you might not even be aware of that could impact your tax situation. This is where a financial planner can be invaluable. They can help you identify and navigate these hidden complexities, ensuring you make informed decisions.
Diversify Concentrated Positions
If your investment with large capital gains represents a significant portion of your portfolio, it’s important to diversify. This is known as a concentrated position. A financial planner can help you develop a strategy to gradually reduce these positions and spread your investments across different asset classes, reducing risk and potential tax liabilities.
Consult a Financial Advisor
Navigating the tax implications of selling appreciated investments can be complex. A financial advisor can provide personalized advice and help you develop a strategy that minimizes your tax liability while aligning with your financial goals.
Remember, while it’s impossible to eliminate all taxes, these strategies can help you minimize your tax burden and keep more of your hard-earned money. By planning ahead and making informed decisions, you can sell your appreciated investments without paying obscene amounts of taxes.
Don't let taxes eat into your hard-earned gains. Contact us to learn how our tax-saving strategies can help you.
Investment advisory services offered through Equita Financial Network, Inc. an investment adviser with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. Equita Financial Network also markets investment advisory services under the name, Astraea Wealth Management LLC. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.