One of the foundational tenets of investing is to start early, letting compounding interest work for you. And the reason we promote this strategy is because it works — many of our clients have been able to build wealth this way. The flipside, however, is that with growing wealth comes a price at tax time.
I’m happy to tell you, however, that there are ways to help mitigate your tax burden.
Understanding capital gains
First, we need to define capital gains. Capital gains are the profit earned on the sale of an asset which has increased over time. Or, in plainer English, when you buy something (from a stock to a vacation home) and sell it later for more than you paid for it, the difference in price is capital gains. Those gains often incur taxes at the federal and state levels.
Knowing your potential tax burden
Capital gains are reported as a type of income on your taxes, and the amount you pay depends on a number of factors, including type of capital gain and your income level. Some extra taxes can be levied if your income is too high, and capital gains income counts toward this. Some examples include:
- Net Investment Income Tax (NIIT): This is a 3.8% tax on income such as interest, dividends, and capital gains. It applies to people with an adjusted gross income above $200,000 for single filers and $250,000 for people filing jointly. This tax applies to one-time spikes as well as recurring income, so windfalls such as an inheritance can be affected.
- Income Related Monthly Adjustment Amount (IRMAA): High income Medicare beneficiaries may pay an additional charge for Part B and D premiums, depending on their modified adjusted gross income. This threshold is adjusted every year to account for inflation. In 2024, single people with an income of $103,000 or higher will pay a higher premium for Part B and D.
Knowing what extra taxes you might incur at your income level can help you make a plan to ease your tax burden.
Strategies for capital gains
The good news is there are ways you can make the most of your capital gains, while potentially minimizing taxes owed.
1. Only recognize long-term gains. There are two types of capital gains: short term and long term. Short-term gains are earned on assets owned for less than a year, while long-term gains are those earned on assets owned for more than a year. Long-term gains are taxed at 0% or 15% for most people, while short-term gains are taxed at the ordinary income tax rate, which tends to be much higher. Also, I want to point out that short-term losses can offset long-term gains.
2. Control when you recognize gains. Because the tax rate on capital gains is tied to your adjusted gross income, look for years when your income is lower to sell assets and recognize the gains. This will keep your tax rate on the gains lower. A typical example we see with our clients is between retirement and when Social Security begins.
3. Control how much you recognize. Not only can you control when you recognize your gains, you also can control how much. First, bring your income up to the IRMAA threshold (and again, remember that this threshold adjusts for inflation annually). You also can harvest your gains in a 0% capital gains bracket. For people in lower income brackets, capital gains are taxed at 0%. If you fall in that bracket, you can sell investments that have appreciated, be taxed at 0%, and buy back those investments to continue investing and earning. This strategy does require being careful, because if your investment income is too high, it will push your gross income level into a higher level and you will no longer be taxed at 0%.
4. Donate appreciated investments to a donor advised fund. If you contribute assets to a donor advised fund, no taxes are required at all. This can be a great strategy for your highest gain assets, as they will incur no tax burden.
Putting it all together
I’m sure you’re thinking “Mallory, this is great, but what is the best way in my specific situation to minimize my capital gains tax?” I’m so glad you asked! The best thing you can do is talk to your tax professional and your financial advisor. Every situation is different and requires a different, individualized strategy.
While I’ve talked in generalities above, you can work with your financial advisor to make a plan specific to you, your needs, your income and your goals. Trust me, us financial advisors love to talk about this!
Mallory is a Wealth Manager and Shareholder. She listens deeply and helps simplify complex financial situations to help clients move into an easier, clearer future. She aims to give financial advice that is compassionate, wise, and easy to understand.