Capital gains taxes are a fact of life for most investors and savers. They are also often a subject of debate in politics and sometimes rise or fall as a result. So it pays to be mindful of how these taxes apply to your situation and educate yourself on strategies you can follow to minimize their impact.
Simply put, a capital gain is the result of selling an asset — a house or stock investment or a diamond ring, for example — for more than it cost. The government taxes that gain. The level of tax depends on a variety of factors, like what type of asset is involved, when the sale occurred, how long you owned the asset, or the taxpayer’s level of income. If you sell your home, for example, a portion of any gain you realized in property value may be exempt from capital gains taxes if you qualify for the exclusion.
For most people, especially as more savings for retirement and other life goals are self-directed, capital gains taxes are encountered in investment securities. That’s why it’s advisable to understand the advantages of:
- Retirement programs qualified for tax advantages.
- Annuities and life insurance.
- How to manage a portfolio for tax efficiency.
Certain retirement programs and accounts are qualified for special tax treatment. So making full use of them will help minimize the capital gains tax bite.
For instance, defined-contribution programs offered by many companies and organizations — like 401(k) accounts for private businesses or 403(b) or 457(b) accounts for nonprofits and public sector organizations — defer taxes on any gains until the money is taken out. Traditional individual retirement accounts (IRAs), SIMPLE IRAs, and Thrift Savings Plans offer the same advantage. (Related: Understanding 401(k)s and similar savings plans)
Within these types of accounts, you can buy and sell investments without triggering capital gains tax. An additional benefit is that you are contributing money on a pre-tax basis, which will reduce your current taxable income.
To that end, you may want to contribute as much as possible to such qualified accounts. In 2020, you can contribute up to $19,500 to a 401(k), 403(b), most 457(b) plans, and TSPs. If you’re 50 or older, you can make an additional catch-up contribution of $6,500. The SIMPLE IRA contribution limit is $13,500 plus a catch-up contribution of $3,000. The traditional IRA contribution limit is $6,000, plus a catch-up contribution of $1,000.
When you take money out of these types of accounts, it is taxed at your ordinary income tax rate (provided you are taking distributions after 59 ½ years of age, otherwise there’s a penalty). Some people expect to be in a lower tax bracket by then, thereby mitigating the tax impact. But that may be a misconception for some people.
“The assumption that you will be in lower tax brackets in retirement may be flawed,” said J. Todd Gentry, a financial professional with Synergy Wealth Solutions in Chesterfield, Missouri. “We no longer would have children as deductions and, for most people, their goal is not to have a lower income in retirement, but what they currently live on. And it’s possible, maybe even probable, that for many people tax rates may go up. So, perhaps, a much more reasonable assumption is that you’re saving into higher taxes in the future and need to plan accordingly.”
Annuities and life insurance
Some types of annuities and life insurance offer ways to soften capital gain tax impacts.
Annuities are basically contracts under which you make payments now in exchange for a stream of payments at a later date. They are often used to help with retirement needs. And some types of annuities, like variable annuities, are designed to offer market exposure to those who want to chase investment gains over and above the guaranteed or interest-rate based returns offered by other types of annuities. (Related: Different types of annuities)
“If you are looking for future tax deferral, a variable annuity shell is a great way to be able to move in and out of investments without incurring a tax in the year you make the change,” said Doug Collins, a financial planner at Fortis Lux Financial in New York City. “You cannot, however, simply move a portfolio of investments into an annuity. That would be treated as if you sold everything.”
Additionally, variable annuities allow investors to defer paying taxes on any gains until the money starts being paid out as income. Such payments, which are typically made in retirement, are taxed at ordinary income tax rates. Importantly, in addition to possible investment returns, variable annuities provide many important features such as a variable annuity death benefit, lifetime income, and optional living benefits. (Learn about variable annuities here)
But such vehicles are not for everyone. A variable annuity involves risk and its value can go up or down, depending on the performance of the underlying investments. Also, there is no additional tax deferral when an annuity is used to fund a qualified retirement plan, like one of the ones mentioned above. And there will be a 10 percent penalty if funds are withdrawn prior to 59 ½ years of age.
“The suitability of a variable annuity is dependent on the entire retirement plan and the need for guaranteed income, a death benefit, and tax planning,” said Jeff Rotman, principal of wealth management firm Rotman & Associates in Fort Lauderdale, Florida. “If you defer gains in some situations, it could increase the amount of Social Secuity benefits subject to income tax. It is imperative to look at the macro-plan in assessing tax now or tax later decisions. This alone is all the reason to seek advice from a financial professional.”
Certain types of permanent life insurance, in addition to offering partial income replacement protection for beneficiaries when the policyowner passes away, also offer tax deferred growth of the cash value component. Money borrowed or taken from the cash value of a life insurance policy is not subject to taxes up to the “cost basis” – the amount paid into the policy through premiums. And the death benefit generally goes to a beneficiary tax-free. (Related: 3 tax advantages of life insurance)
“Life insurance allows you some dynamic avoidance of capital gains and income tax,” said Gentry at Synergy.
Variable universal life insurance, in contrast to other permanent policies, provides investment options for cash value accumulation. VUL policies may appeal to those who seek tax-deferred growth of their cash value based on investment returns, in addition to basic life insurance protection for their family and loved ones. But, again, such policies involve market risk and aren’t for everyone. (Related: Understanding VUL policies)
How you manage your portfolio can also affect the degree to which capital gains taxes factor into your returns.
For instance, you can potentially use losses in some investments to offset a portion of capital gains taxes in others. For example, if you had a gain of $2,000 from the sale of Stock A, but saw a loss of $1,600 in Stock B, you could take the $1,600 loss and use it to offset part of your $2,000 gain. The net capital gain would then be only $400. You would pay capital gains tax on that smaller $400, rather than the larger gain of $2,000.
“If you have a lot of built up capital gains, the first thing to do is look to offset gains with losses,” said Collins at Fortis Lux Financial.
If you have more losses than capital gains in a given year, you may be able to deduct your loss from ordinary income instead, up to $3,000 a year ($1,500 if you’re married and filing separately). Any excess can then be carried over to future years indefinitely as a deduction against investment gains or ordinary income.
Also, you should monitor the hold times for investments to make sure you are not selling any too early. If you sell holdings less than a year after you bought them, the transaction is subject to short-term capital gains tax rates, which are higher than long-term capital gains tax rates.
Short-term gains are taxed at your regular marginal income tax rate. Long-term gains are taxed at 0 percent, 15 percent, or 20 percent, depending on your taxable income.
Similarly, you have to keep track of the cost basis for each investment, that is, what how much the investment originally cost you. That is the mark from which any gain will be measured. This can get to be a tricky proposition if you bought shares of the same company or investment fund at different prices and at different times. There are different methods for calculating the overall cost basis. But what’s appropriate in the eyes of the IRS depends on the specific circumstances. In the case of a significant holding or transaction, many people opt to consult an investment professional or tax specialist.
These are just three basic approaches to minimizing the impact of capital gains taxes. There can be a plethora of strategies to take advantage of depending on the individual circumstances, holdings, and goals. Many people often look to fit such moves into their broader framework of financial planning, with the help of a financial professional. (Need a financial professional? Let us know)
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