Lowering Capital Gains Taxes: Smart Strategies for You
Earning investment gains can feel good until the tax bill comes. Learn ways to help lower capital gains taxes with specific strategies—and help from your financial and tax professionals.
Key Takeaways
Investment gains can come with up to 20% in income taxes, depending on your investment income, according to the IRS. Understanding the rules can help lower your income tax bill.
A tax-loss harvesting strategy can help you reduce your tax obligation by offsetting capital gains with capital losses.
Working with financial and tax professionals can help you determine what action you can take to make your portfolio more tax efficient.
Capital gains taxes can take a bite out of your profits if you sell shares that are worth more than when you bought them. According to the IRS, long-term capital gains may be taxed at 0%, 15%, or 20%, plus 3.8% of Medicare Surtax, depending on your income and tax filing status.
Managing investment taxes can add complexity to your financial plan, and clients frequently ask us how they can minimize these annual taxes. Financial consultants Amy Alley, Rowland Pepito and Jennifer Simmons discuss common tax topics and provide insight into evaluating your investment and tax plans. Let’s start with a quick recap of how investments are taxed.
Capital Gains Tax Refresher—When and How Much?
If you’ve been investing for a while, you know you may owe taxes on realized long-term and short-term capital gains when you sell shares in your taxable accounts. Long-term capital gains apply to investments held for more than a year and are generally taxed at a lower rate than your ordinary income tax rate.
Short-term capital gains apply to investments held for a year or less and may be taxed as ordinary income, based on your income tax bracket.
Of course, you could sell shares that have lost value, giving you a capital loss. If you have both capital gains and losses, your taxes may be reduced because losses can offset the gains. In that case, you pay taxes on your net capital gain. Later, we'll discuss how this applies to the tax-loss harvesting strategy.
Either way, you will pay taxes on “realized” gains—meaning when you sell the shares. Here’s what to know about realized gains and unrealized gains.
Taxes you pay in a tax year are based on “realized” gains when you sell shares in taxable accounts. If you don’t sell, you have “unrealized” gains that you pay taxes on when you do sell. However, if you own a mutual fund or ETF, you may owe taxes if the investment distributes capital gains from selling securities within the fund or ETF.
How Can You Lower Your Capital Gains Tax Bill?
There are strategies you can use, including tax-loss harvesting and working with a professional to review your tax options and opportunities, to help lower your capital gains taxes. Whichever strategy you use, we think it helps to start by talking to a professional.
Talking to an Advisor About Tax Efficiency
Some clients are more aware of their tax obligations and the complexities involved than others. Their knowledge may depend on how long they’ve been investing, the types of accounts they hold (taxable versus tax-advantaged), or the size of their investment portfolio.
“There’s a lot of fear of the unknown,” says Jennifer. “People have an aversion to talking about taxes, wanting to believe that they’re not going to get a surprise bill at the end of the year. The more specific we can be and apply strategies to their situation, the more they can overcome that fear.”
Clients understand that investments can come with a tax burden. But investing can be more tax-efficient than they think—they may pay less tax on investment income generated from their portfolios on regular ordinary income, thanks to the benefits of preferential qualified dividends and long-term capital gains, or municipal bond income. The challenge is that investments don’t offer a tax withholding mechanism to avoid a year-end tax bill, especially as the portfolio income grows.
Get Answers About Tax-Efficient Investing
You may need to start at the beginning and understand tax efficiency in general. Rowland says he starts there with his clients, then provides examples.
“In some years, we’ve seen a big down quarter at the beginning of the year, but the end of the year ends with gains. That lets us look at the ‘what ifs’ about the losses,” he says. “What if the investor realized and netted those early losses with portfolio gains at the end of the year?” Effectively, they may have reduced their tax obligations because realized losses at the beginning may offset later gains.
And that brings us to an often-overlooked strategy to manage taxable gains: tax-loss harvesting.
Tax-Loss Harvesting: Offsetting Taxable Gains With Losses
With this strategy, an investor intentionally sells an investment at a loss and reinvests the assets elsewhere. The goal is to offset taxable gains with those losses, thereby potentially lowering the overall tax burden, all while staying invested in the market.*
Tax-Loss Harvesting Is Not for Tax-Advantaged Accounts
Tax-loss harvesting should only be used for taxable accounts, not tax-advantaged accounts like IRAs, 401(k)s, Roth accounts and 529 education savings accounts. Within tax-advantaged accounts, capital gains, interest and dividends are generally tax deferred until distributions or tax free if certain requirements are met.
According to our consultants, most of their clients don’t use the term “tax-loss harvesting.” Discussions often start by identifying pain points, and taxes on gains are often at the top of the list. Clients will then ask about tax-loss selling, offsetting or even “write-offs,” but they have the same end goal: minimizing taxes and keeping more of the investment income.
“We talk through methods to reduce their tax obligations,” says Amy. “We help them understand that tax-loss harvesting has the potential to be a win-win—you have a taxable gain in your fund and can still lower income taxes.”
Year-End Is Not the Only Time to Consider Tax Strategies
Tax-loss harvesting is often seen as an end-of-year task, but Amy stresses that it’s important to consider the strategy as the opportunity arises year-round. “We don’t address it every year,” she says. “But if there’s a market drop, it might be time to harvest strategic losses for the year.”
Another strategy to consider when mutual fund capital gain distributions come out, clients can redirect those into something more tax-efficient and avoid compounding the problem by buying more shares each year.
Can You Go Overboard With Tax Loss Harvesting?
Investors can take this strategy too far, such as liquidating large positions to capture a negligible tax loss. Or they may think that selling investments to offset taxes is the end of the story. It isn’t.
Reinvesting is important to avoid missing out on potential market returns. (See the “wash sale” rules regarding reinvesting in the same investment.) An advisor can help you determine where to allocate the assets as part of your overall investment plan as the tax-loss harvesting can be incorporated while replacing the investment portfolio.
How Can You Invest More Tax Efficiently?
Tax-efficient investments, such as exchange-traded funds (ETFs), are getting a lot of attention because their tax treatment is more efficient relative to mutual funds. They also tend to be favored in taxable accounts, a practice commonly referred to as asset location. Other tax-efficient options include investing in tax-advantaged accounts, such as IRAs, Roth IRAs or your workplace retirement plan.
Clients often want to understand how taxes could affect their wealth-building goals. Discussing taxes in your financial plan can help you and your advisor develop smart strategies to get your investments to work more efficiently for you and potentially lower your taxes. This can be accomplished through tax diversification along with the asset allocation of your portfolio.
Compare investment options to help optimize your tax benefits and potential growth with our Tax Calculator.
Team Effort: Working With a Tax Advisor
Tax planning conversations are a benefit of having a relationship with a financial consultant and can potentially enhance your investment returns. You can work together to find blind spots and opportunities.
While our consultants can talk through investment-related tax issues, they don’t provide specific tax or legal advice. On the flip side, tax professionals understand how investments are taxed but may not know the ins and outs of your unique investment portfolio. That can make it hard for clients to know when to take action.
Getting a tax advisor on board to run the tax projection numbers can help clients feel more confident putting a tax-loss harvesting strategy into place. CPAs may not be as familiar with investments, but they are a great resource for helping clients become comfortable with the concept.
Authors
Financial Consultant
Financial Consultant
Financial Consultant
Discuss Tax Strategies With an Advisor
You can get a financial plan that includes tax strategies in a session or two with one of our financial advisors. Or, opt for in-depth financial planning and advice.
Long- and short-term capital gains are taxed at different rates. Long-term gains may be offset by long-term losses. Likewise, short-term gains may be offset by short-term losses. The net losses from one category can offset the net gains from another category. Any net losses may offset up to $3,000 in ordinary income, with the reminder carrying forward to future years.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
IRA investment earnings are not taxed. Depending on the type of IRA and certain other factors, these earnings, as well as the original contributions, may be taxed at your ordinary income tax rate upon withdrawal. A 10% penalty may be imposed for early withdrawal before age 59½.
Please consult your tax advisor for more detailed information regarding the Roth IRA or for advice regarding your individual situation.
Taxes are deferred until withdrawal if the requirements are met. A 10% penalty may be imposed for withdrawal prior to reaching age 59½.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
American Century's advisory services are provided by American Century Investments Private Client Group, Inc., a registered investment advisor. These advisory services provide discretionary investment management for a fee. The amount of the fee and how it is charged depend on the advisory service you select. American Century’s financial consultants do not receive a portion or a range of the advisory fee paid. Contact us to learn more about the different advisory services. All investing involves the risk of losing money.