Kevin Casteel, CFP® Trust Officer, Financial Planner
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Key Highlights
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Leveraging tax strategies for securities and other appreciable assets subject to traditional capital gains tax rates could help preserve your wealth by lowering your tax liability. Your wealth management team and tax advisor should be able to identify and implement strategies to minimize your capital gains taxes and harvest your investment gains in a tax-efficient manner. Here are six strategies you may want to consider.
Hold your investments for more than one year
The IRS has higher tax rates for short-term capital gains, so holding your investments longer than one year before selling them allows you to take advantage of lower long-term capital gains tax rates. For example, if you buy positions in a stock that appreciates in value and then sell those stock positions within one year (365 days), the gains are treated as short-term gains and would be taxed at the same rate as your regular income. The net gains are subject to between 10% to 37% in taxes depending on your taxable income and filing status.
By contrast, if you hold onto those same stock positions for longer than one year before selling them, your net gain would be taxed at long-term capital gains tax rates instead of your regular income tax rates. Depending on your taxable income and filing status, long-term capital gains tax rates are between 0% and 20%. Holding assets for longer than one year before selling them can significantly lower your capital gains taxes, particularly for high earners who are taxed at higher income tax rates.
Some assets are exceptions to the maximum 20% long-term capital gains tax rate for investment gains. For example, if you sell appreciated qualified small business stock or collectibles, these assets would be taxed at a top rate of 28%. Real estate also has its own unique considerations regarding capital gains.
Bequeath appreciated assets to receive a step-up in cost basis
If you are planning to give appreciated assets to family members, it may be more tax-efficient to hold onto these assets during your life and transfer them when you pass away. Appreciated assets generally receive a step-up in cost basis when they are inherited. For tax purposes, the original value of the asset is recalculated to its fair market value on the day its owner passes away.
For example, if you purchased assets such as stocks, bonds, or mutual funds for $100,000, that grew in value to $250,000, you would owe capital gains taxes on the $150,000 of net gains if you were to sell the investment, as the cost basis would be the purchase price of $100,000. If instead you bequeath the same asset to your child and it is worth $250,000 when you pass away, the new cost basis value becomes $250,000.
When your child sells the asset, any gains or losses will be relative to the new cost basis of $250,000, meaning they could sell it soon after inheriting and likely owe little to no capital gains taxes. Because inherited assets are automatically considered long-term, even if sold shortly after inheritance, your child will benefit from the more favorable long-term capital gains tax rates. Or if your child holds onto the asset and then sells it once it appreciates to $300,000, they will owe capital gains taxes on the $50,000 that exceeds the new cost basis value of $250,000.
Timing capital gains harvesting to maximize tax efficiency
Since capital gains tax rates increase as your ordinary taxable income rises, realizing gains in years where you have lower taxable income or harvesting gains over multiple years can lower your overall tax liability. If you suspect realizing gains may push you into a higher tax bracket, you might consider spreading the gains over multiple years or timing them in lower-income years.
For investors who may be heavily concentrated in a specific company’s stock and have significant gains from stock-based compensation or from investing in the same security multiple times throughout their lives, the cost basis value of the stock positions becomes especially relevant for tax management.
One strategy involves selling lower cost basis assets first in years where your taxable income is lower since there is more appreciation subject to capital gains taxes. For lower cost basis assets, the difference between the original purchase price and the current market value is larger, which means a larger portion of gains will be realized and would lead to higher capital gains taxes. If you want liquidity but are concerned about incurring a larger tax liability, you could sell the higher basis assets first to realize smaller gains.
Similarly, if you are considering selling assets with significant gains that could push you into a higher tax bracket or incur a surtax, gradually selling the assets over multiple years may be more tax-efficient than selling all at once. For instance, the net investment income tax (NIIT) is a 3.8% surtax on investment income for those with a modified adjusted gross income (AGI) over $200,000 for single filers and $250,000 for married couples filing jointly. If your modified adjusted gross income is close to that threshold, you might consider harvesting gains over multiple years to stay below the net investment income tax threshold.
Use tax loss harvesting to offset capital gains
Tax loss harvesting is a strategy that involves selling an asset for a loss to offset capital gains from other investments or to reduce your ordinary taxable income, which can ultimately lower your capital gains and income taxes.
For example, say you realize a net loss in one stock of $50,000 and a net gain in another stock of $40,000 in the same year. Since losses can be used to offset gains, you will not owe capital gains taxes on the $40,000 of net gains since you lost more than you gained that year.
Once your losses offset the $40,000 of gains, there are $10,000 worth of losses left over. The IRS allows a capital loss deduction which can be used to reduce your ordinary taxable income which may lower your income tax liability.
You can only use the capital loss deduction to reduce your taxable income up to $3,000 in any given year. In this example, once you use the $3,000 to lower your taxable income, the $7,000 in total net losses that remain can either be applied to offset future realized gains or lower ordinary taxable income the following year. Additional losses are carried over to the following tax years to provide the same benefits of offsetting realized gains or lowering your ordinary taxable income until they are exhausted.
You might consider harvesting gains in years where you realize a large loss, or if you have losses that have been carried forward from prior years. By offsetting your gains with these losses, you may reduce your capital gains tax liability for that year.
If done prudently and efficiently, tax loss harvesting is a strategy that can save you a sizable amount of money in the long term. There is a balance to be struck, however, since it may not make sense to realize losses from positions you would like to remain invested in. Investments you intend to sell and do not plan to reinvest in may be ideal candidates for tax loss harvesting, allowing you to offset taxable gains from other investments or lower your taxable income once you exit those positions.
Give appreciated assets to a qualified charitable organization
Generally, if you donate appreciated assets held for more than one year to a qualified charitable organization, you can forgo paying capital gains taxes and deduct the fair market value of those assets up to 30% of your adjusted gross income. This deduction lowers your taxable income, potentially reducing your income tax liability. Not all organizations, however, fit the IRS qualifications to receive deductible contributions.
Donating appreciated assets to charity effectively resets your cost basis to its full level. Instead of selling the asset and paying taxes on the gains to make a cash donation, you could donate the asset directly without selling it and paying capital gains taxes.
Charitable trusts, donor-advised funds, and private foundations also have tax benefits. Learn more about these charitable giving strategies to see how they can help you in your overall financial goals.
Prioritize allocating assets to tax-efficient accounts
Tax-advantaged accounts like health savings accounts, retirement accounts, and 529 plans do not typically incur capital gains taxes for certain transactions within the account. Allocating assets to these types of accounts with significant potential for appreciation may be more tax-efficient than holding assets in a taxable investment account.
Tax-advantaged accounts, however, often require you to give up flexibility in how you can use the funds and can have other tax implications when you withdraw funds from the account. For example, traditional IRAs allow earnings to grow tax-free, but withdrawals are taxed as ordinary income, with early withdrawals (those taken before age 59 ½) subject to an additional 10% tax penalty.
For taxable accounts, avoiding assets that are inefficient for tax purposes may lower your capital gains taxes. For example, actively managed mutual funds that involve frequent buying and selling of securities may generate a substantial tax liability, especially if short-term gains are realized and taxed at ordinary income tax rates.
Engage the Commerce Trust team of specialists who can advise you on strategies that fit your financial and investment goals
Identifying effective strategies to manage your capital gains taxes requires a full understanding of your financial goals. With the team-based approach at Commerce Trust, your private wealth management team of financial and tax planning, investment portfolio management, and trust administration specialists can work with your tax advisor to tailor your investment and tax strategies and ensure they are implemented to support your unique objectives. Additionally, Commerce Trust can offer comprehensive tax planning services* to further support your financial strategy.
Contact Commerce Trust today to learn more about how our team of specialists across multiple disciplines stands ready to provide customized financial planning, investment management, and tax management* services under one roof.
*Commerce does not provide tax advice to customers unless engaged to do so.
Certified Financial Planner Board of Standards. Inc. (CFP Board) owns the certification marks CFP® and CERTIFIED FINANCIAL PLANNER™ in the United States, which it authorizes use of by individuals who successfully complete CFP Board's initial and ongoing certification requirements.
The opinions and other information in the commentary are provided as of October 29, 2024. This summary is intended to provide general information only, and may be of value to the reader and audience
This material is not a recommendation of any particular investment or insurance strategy, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified tax advisor or investment professional. While Commerce may provide information or express opinions from time to time, such information or opinions are subject to change, are not offered as professional tax, insurance or legal advice, and may not be relied on as such.
Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
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