For many people, capital gains tax is a mystery. It’s one of those tax issues you don’t know about unless you have to.
Capital gains tax is a tax that is charged on gains that are earned from investments. The tax applies to dividends and gains that are made on stocks, bonds, real estate, art and collectables.
Before we get into specifics, you should know that the tax rates on investments can be much lower than taxes on wages. The idea behind this preferential treatment is that “invested” capital has the ability to create knock-on benefits in the economy. So if you invest in a company, and that company uses your money to hire employees, the money you invested had the extra benefit of creating jobs. Because of this benefit, the US tax system gives investment earnings a tax break.
But there are critics of this arrangement. Some say that not all investment is productive. Some investment is what is deemed as “rent seeking”, which is an investment that merely generates revenue but delivers no economic value. Many Wall Street innovations are seen as purely speculative (derivatives or collateralized debt obligations, anyone??), and are deemed by many to be rent-seeking products. Even the act of a landlord raising his rent can be seen as non-productive (nothing new has been created, no jobs were created and only the landlord benefits).
So what does this mean to you?
Let’s start by looking at how capital gains tax rates can be lower than your personal income tax rate. If you are single and earned just over $100,000 from you job last year, the income made from the sweat of your labor will be taxed up to a maximum of 28%. But, if you didn’t work at a job at all last year, and on December 31st you sold your Facebook stock for a $100,000 profit, the tax rate on the $100,000 of capital gains would be 15%. The difference is quite large.
And the lower rates happen at every tax bracket. The capital gains rate is 0% for individuals in the 10% and 15% income tax brackets. For those in the 25%, 28%, 33% and 35% income tax brackets, the capital gains rate is 15%. And at the top income tax bracket of 39.6%, the capital gains rate is 20%.
But there is something very important to note. In order to benefit from the capital gains rate, your investment must be held for more than a year (at least 366 days). If you do, you qualify for the reduced tax rate. If you don’t hold it that long, your gain will be taxed at the higher personal income tax rate.
So holding investments for more than a year makes a big difference!
A couple of extra things to note:
- Qualified dividends (which includes most dividends paid by US listed corporations) fall under the lower long-term gains rate. But… in order to keep people from buying a stock right before the dividend is issued and selling it right after, the IRS wants you to own the stock for at least 61 days within the 180 days around the dividend date, in order to have it deemed a qualified dividend.
- Interest income is taxed at your higher personal income tax rate. So the money you get in interest from your bank accounts or from bonds does not get the lower capital gains rate.
- Not all real estate falls under the lower capital gains rate. If you sold depreciated real estate, that amount is taxed at a higher rate.
- Gains made from the sale of art and collectibles (including, for example, your grandfather’s baseball card collection) is taxed at it’s own capital gains rate of 28%.
So take advantage of the lower tax rates on capital gains! But as a side note, make sure you have the money ready at tax time! It’s nice to have made a good chunk of money on the sale of an investment, but remember that you will have to pay tax on it when you file your tax return!
In the alphabet soup of tax lingo, tax credits rule! Credits are dollar for dollar reductions in the amount of tax you owe. And with some credits, they can reduce your tax to less than zero, allowing you to get some of the credits as a refund! Cha ching!
But the first thing you should know is that tax credits generally have earnings limits. So if you make too much money, the credits may not be available to you. But check anyway. You could be in for a surprise.
So here are the available tax credits:
- The Earned Income Tax Credit, sometimes called EITC, is a tax credit to help lower wage earner keep more of what they’ve earned. To qualify, you must have earned at least $1, earned less than $3,400 in investment income, had no foreign earnings and earned less that the earnings ceiling. The earnings ceiling ranges from $14,820 for a single filer with no kids, up to $53,267 for married filers with 3 or more kids. Check here for the exact limits. You must also file a tax return to get the credit.
The best part of this credit is that it is a refundable credit, which means that if it lowers your taxes to less than zero, the excess will be given to you as a refund. It’s a terrific benefit of the credit.
Unfortunately, an estimated 25% of people who qualify for the EITC do not apply for it. But if you missed applying for it, you can still apply up to three years later. Make sure you check it!
- There are two credits available for education. The American Opportunity Tax Credit(AOTC) is available for qualified education expenses, and has a maximum credit of $2,500. The individual earnings cap is $80,000. It is available for the first 4 years of a degree or other recognized program. The Lifetime Learning Credit (LLC) is available for tuition and other education expenses at any qualified institution. There is no limit to the number of years you can get the credit. The maximum credit is $2,000 and the earnings cap is $55,000 for individuals.
- If you made less than $27,750 as an individual, $41,625 as a head of household or $55,500 as married and filing jointly, you can get up to $2,000 in credit for contributions you made to a retirement savings account (an IRA or 401(k)). This credit can be used in addition to the deductions that can be gained from contributions to traditional IRAs.
These tax credits are terrific ways of cutting your tax bill down. Make sure you check to see if you qualify for them. A little bit of research can put a big chunk of money in your pocket.
What a great problem to have! If you’re trying to reduce your capital gains, it means you made some money on your investments.
It’s important to know that the tax rates on investments can be much lower than taxes on wages. So if you are in a high tax bracket, your earnings from actual labor will be taxed at 35%. But, the money you made when you sold your Apple stock, for example, will be taxed at a lower 15% tax rate! The US tax system definitely looks more favorably on money earned through investments.
So the first and most important thing to know is that there are two capital gains tax rates. One, the preferred, lower rate is the “long-term” rate. The second, higher rate is the ”short-term” rate. The difference between the two is time. One calendar year to be exact. So if you hold an investment for more than a year (366 days or more), your gains will be taxed at the long-term rate and if you hold the investment for less than a year, the gain will be taxed at the short-term rate, which is the same as your personal income tax rate. The difference between the two can be significant.
For people filing taxes as single, these are the rates (2016):
Income between $0 and $9,275: Short-term rate 10%, Long-term rate: 0%
Income between $9,275 and $37,650: Short-term rate 15%, Long-term rate: 0%
Income between $37,650 and $91,150: Short-term rate 25%, Long-term rate: 15%
Income between $91,150 and $190,150: Short-term rate 28%, Long-term rate: 15%
Income between $190,150 and $413,350: Short-term rate 33%, Long-term rate: 15%
Income between $413,350 and $415,050: Short-term rate 35%, Long-term rate: 15%
Income over $415,050: Short-term rate 39.6%, Long-term rate: 20%
As you can see, the difference in tax rates is significant. So holding investments for more than a year makes a big difference.
Also note that qualified dividends (which include the vast majority of company issued dividends) fall under the lower long-term gains rate.
The other way to lower your capital gains tax is to sell losing investments before the end of the calendar year. If you have incurred significant gains during the year and also hold some investments that are losing money, you can sell the losers, thereby lowering your overall gains. Always look at your portfolio at the end of the year with an eye to possibly selling your losing investments; especially in years you made significant overall gains.
But a note of warning if you sell losing investments, you cannot re-purchase a “substantially identical” investment for 30 days. Otherwise the loss will be a deemed a “wash sale” and your loss cannot be applied to against your capital gains. So be careful when you repurchase the same stock or fund. You don’t want to erase a significant tax benefit.
Another way to lower your capital gains is to use a Roth IRA account. This is a unique retirement account allows you to not only grow your money tax-free, but also to withdraw the money tax-free. It is a terrific way of lowering your capital gains rate to zero. No other retirement account allows you to grow your money completely capital gains free.
There are some limits to Roth IRAs. For one, in order to contribute to a Roth IRA account, you have to qualify under the earning limits (which you can find here at the IRS web site). Also, you cannot withdraw the money before you turn 59 and a half and you must have been contributing to the account for at least 5 years. If you do withdraw money early, you will be hit with a 10% penalty. Also note that you can only contribute after-tax money to this account, so it doesn’t save you tax money right now. But other than that, Roth IRAs are a great way to grow your money tax-free.
The tax system likes long-term investing, and favors those who follow a ‘buy and hold’ strategy. So open a Roth IRA if you can. If not, keep your eye on the calendar, and when you hit the one-year mark holding an investment, have a little celebration because you’ll have suddenly saved a significant amount of tax!
So you want to reduce your taxes? Don’t we all!
There are three ways to reduce taxes. First is to reduce your taxable income, second is through credits and third is though deductions.
First of all, you should know that most tax reduction strategies are capped by earning limits. If you earn too much money, you won’t qualify. But make sure you check the limits. Many people miss the benefits because they mistakenly believe that they don’t qualify. Make sure you check.
The first tax reduction strategy comes from income reductions. If you can lower your taxable income, you’ll lower your tax bill. This can be done in a number of ways. Contributions to 401(k)s can almost always be used to reduce your taxable income. Employer based flex-spending accounts for expenses such as transit, parking, education and child care can also usually be used reduce your taxable income.
These plans divert your income into retirement and benefit accounts, before it gets to your paycheck. Your paycheck is therefore lower by that amount, and you never pay tax on that income. It is a direct tax reduction strategy whose tax benefits appear on every paycheck.
Second, use credits to reduce your taxes. Make sure you check if you can get the Earned Income Credit on your tax return. The Earned Income Tax Credit is a tax credit to help lower income workers keep more of what they earn. To qualify, you must meet certain requirements and file a tax return, even if you do not owe any tax or are not required to file a return. An estimated 25% of people who qualify for the EITC do not apply for it. And if you forgot to apply, you can still get it credited for the last three years. Make sure you check it! And the benefit can lower your taxes to less than zero, with the excess given as a refund.
There are also credits available for education, childcare and for savings. These are geared to people earning under $50,000 per year, so check to see if you qualify for these.
Lastly are deductions. These are things you can claim that lower your taxable income. It isn’t a dollar for dollar benefit, but they reduce your tax by essentially showing you have less income to tax. Here is a list of things that can be used as deductions:
- Contributions to traditional IRAs (subject to earnings limits)
- Interest on student loans
- Interest on mortgages
- Property taxes
- State and local taxes
- Charitable donations
- Some medical expenses
Also, if you had a net loss in the stock market (or any net capital loss), you can claim up to $3,000 of that loss as a reduction of your income. Any loss over $3,000 can be rolled over to future years.
If you add up these deductions, see if they are greater than these standard deductions. If they are greater, you should itemize your deductions in your tax return. It will save you money.
|Filing status||Standard deduction|
|Single or Married filing separately||$6,300|
|Married filing jointly or Qualifying widow(er) with dependent child||$12,600|
|Head of household|
Also be aware of other miscellaneous deductions. If they amount to over 2% of your adjusted gross income, you can claim them too. These include:
- Dependent care
- Tools for work
- Magazine subscriptions
- Fees you pay to get your taxes prepared
- Expenses incurred looking for a job
Don’t worry if you’re confused. This is confusing! If you qualify for a lot of the deductions and credits, it may be a good idea to get some help. There are a lot of tax preparation services online that are good and cheap. Many have free tools to help guide you through the process. Most also file your federal return for free. Take advantage of them!
Wouldn’t it be nice to delay paying your taxes? If you are working and trying to save money, wouldn’t be nice to skip your tax for a while so you have more money in your pocket?
Well, there are a few things you can do to delay paying taxes. These deferrals do not eliminate your tax, but rather delay them until you are better able to pay the tax, or until you retire when your tax rate should be lower.
Most of these deferral schemes are attached to retirement plans. We’ll go over two of them.
The primary vehicle for deferring tax is through employer sponsored 401K plans. The money that goes into a 401K is usually “pre-tax” money. This means that your contribution comes out of your paycheck before tax is applied. This money will eventually be taxed, but not until it is withdrawn from the account after you retire. This benefit also applies to the matching contributions that come from your employer.
The second tax benefit of 401Ks is that any gains you make on the investments inside the 401K are not taxed. So, as you buy and sell investments, or earn dividends, you incur no capital gains taxes that could take a chunk out of your investments. This allows greater compounding and growth of your retirement money.
Once you start taking funds out of a 401K, the withdrawals will be taxed as ordinary income. And once you have retired, your tax rate should be lower than when you were employed. This deferral of taxes until you’re in a lower tax bracket is the key benefit of a 401K.
Another vehicle for deferring tax is through a Traditional IRA. But there is a catch to Traditional IRAs. If you or your spouse has access to a retirement plan at work, then the benefit of pre-tax contributions can vanish. The lines are drawn according to earnings limits and how you file your taxes. Check the IRS web site to see the earning limits.
But even if your Traditional IRA contributions are “non-deductible” (after-tax), the contributions can still grow in the account tax free, thereby avoiding capital gains taxes that would be applied in a regular account.
Like a 401K, funds in Traditional IRAs are taxed as ordinary income when they are withdrawn in retirement, when your tax rate is (hopefully) lower.
There is one other account we should mention: A Roth IRA. These accounts are not tax-deferred accounts. You contribute after-tax money, so the tax advantages do not involve deferring your tax. But there are significant tax benefits to these accounts. The funds in these accounts can grow tax free like in a traditional IRA and 401K. But best of all, once you retire, your withdrawals are “tax exempt.” You’ve paid tax on these funds before they went it, so your withdrawals are tax-free.
There are earning limits associated with these accounts. If you earn too much, you will not be eligible for a Roth IRA. To see the earnings limits, check the IRS web site here.
One very important thing to note with all of these accounts is that they are geared towards retirement. If you need to access these funds before retirement, you will incur a 10% penalty on the withdrawal as well as all applicable taxes. This will result in a substantial loss of savings. Make sure any money you put into these accounts doesn’t need to be accessed before you retire.
One final way the US tax system allows for tax deferrals is through a 1031 like-kind exchange. These are specifically created for people using property as an investment. It allows for the deferral of capital gains taxes on the sale of an investment property if the proceeds are rolled into a “like-kind” property that is identified within 45 days and bought within 180 days. It is a very specific, very complicated benefit, but one that can defer capital gains tax indefinitely.
We should also note that this benefit does not apply to second homes or vacation properties. Sorry! The property in the sale must be an investment property. But property can include things like art or antiques, as long as they were purchased as an investment.
In the end, you can’t really avoid paying tax. You’ll have to pay them some time. But you can defer it into the future giving you some flexibility about when you want to pay. Hopefully these opportunities will leave a bit more money in your pocket when you most need it and help you save for the future.