When you sell an investment, home, or other property for more than you bought it for, you may have to pay capital gains tax. That’s “may have to” not “will have to,” because there are several strategies you can use to avoid capital gains tax or at least reduce what you’ll owe.
Table of Contents
- Use a Roth IRA or Roth 401(k)
- Use a Traditional IRA or 401(k)
- Manage Your Tax Bracket
- Choose Specific Shares to Sell
- Use Capital Losses
- Selling Your Home
- Donate Appreciated Shares
- Buy and Hold
Use a Roth IRA or Roth 401(k)
When it comes to investments, one of the best tax shields is a Roth IRA or Roth 401(k). The money inside of a Roth account grows tax free. There are no taxes on any capital gains, dividends, or interest inside of the account. There are no taxes when you withdraw the money.
The only catch is that you can’t withdraw the money before you reach retirement age. If you’re saving for retirement, that isn’t really a concern.
And with a Roth IRA, you can withdraw the money you contributed without taxes or penalties at any time after your account has been open for five years.
Use a Traditional IRA or 401(k)
Traditional IRAs and 401(k)s come with slightly different tax benefits than Roth accounts. Like Roth accounts, you never pay taxes on capital gains, dividends, or interest inside of your account.
The difference is that when you withdraw money in retirement, you pay your ordinary income tax rate on the amount you withdraw. That’s a trade for getting a tax deduction when you contribute.
Manage Your Tax Bracket
If you make under a certain amount per year, you may qualify for a 0% capital gains tax rate. That means that even if you have capital gains in a taxable investment account, you won’t pay capital gains tax.
If your income is higher, you may be able to qualify for a 15% capital gains tax rate instead of the higher 20% rate.
Capital Gains Tax Brackets
|Single and Married Filing Separately||0%: 41,675|
|Married Filing Jointly and Qualifying Widower||0%: $83,350|
|Head of Household||0%: $55,800|
|Trusts and Estates||0%: $2,800|
Choose Specific Shares to Sell
If you have multiple shares of an investment, you may have some shares that are currently at a gain and others that are currently at a loss. You can pick the specific shares you sell using the specific identification cost-basis method.
All you have to do is say you’re selling the shares that are down. Then you have a capital loss deduction instead of a capital gain.
Use Capital Losses
Capital losses can also offset your capital gains. Let’s say you sell shares of Company A at a $10,000 gain and Company B at a $10,000 loss. The gain and loss will generally cancel each other out so you won’t have to pay tax on the $10,000 gain.
Selling Your Home
If the asset you’re selling is your home, you get an additional exclusion from capital gains taxes. The first $250,000 in gains as a single filer or $500,000 gains as a married couple is exempt from capital gains tax as long as you used the home as your principal residence for at least two out of the last five years.
Donate Appreciated Shares
If you were planning on donating to charity, donate appreciated shares instead of cash. When you donate shares, you get a deduction equal to their current value but don’t have to claim any capital gains. The charity also doesn’t have to pay capital gains tax, so you’re not passing any taxes on to them or reducing what they’re getting.
Buy and Hold
There are valid reasons to make trades instead of just buying and holding, but you should understand the tax consequences. Every time you make a trade, you have to pay capital gains tax. If you hold, you don’t pay taxes until you sell.
Here’s an example of a $100,000 starting portfolio with a 10% return per year. The buy and hold portfolio doesn’t pay capital gains tax until selling. The trading portfolio pays 20% capital gains tax on the gains for each year effectively reducing the return to 8% per year.
|Year||Buy and Hold||Trade|
The longer you hold, the wider the gap grows. And while the buy and hold portfolio will have to pay taxes on selling, the net portfolio is still higher than the trading portfolio. Since you usually wouldn’t sell all at once, you’ll also be able to take other steps to reduce your capital gains tax if you buy and hold.
With all the options available, it may be easier to avoid capital gains tax than you think. It just takes a little planning.