The rate of return on investments is important, but have you considered how taxes affect it? Your after-tax return on an investment is the return after you pay the necessary tax bill. As you’ll see, taxes play an important role in determining when you should sell an asset.
Capital Gains Tax Explained
Let’s say you purchased 1,000 shares of a stock that cost $50 per share. Your cost basis, or the original price you paid, is $50 per share (or $50,000 total).
If you’d like to sell your stock because it appreciated to $75 per share, you must consider what the tax consequences would be. This is because a capital gains tax occurs when you sell certain assets for more than you paid for them.
If you are thinking of selling an asset that has increased in value and are wondering about taxable implications, here are several factors to consider:
Is the gain realized or unrealized?
The first thing to remember is capital gains only occur when you sell the asset. Just because you finished the calendar year with a gain of $25,000 doesn’t mean you’ll pay taxes. Because this gain is unrealized you won’t have to worry about capital gains tax.
Is the asset in a tax deferred account?
Second, when dealing with securities like stocks, bonds, ETF’s, and mutual funds, the type of account you have the asset in affects whether you’ll owe capital gains tax or not.
Some accounts like IRA’s, 401(k)’s, Health Savings Accounts, and annuities are tax-deferred accounts. You can sell assets in these accounts without triggering a capital gains tax. Tax on these accounts are deferred until you make withdrawals (excluding certain tax-free accounts like Roth IRA’s).
However, a taxable brokerage account or mutual fund account that’s not tax-deferred will report capital gains for any sales.
How long have you owned the asset?
Third, the amount of tax you owe on your capital gain depends on the length of time you held the asset.
Assets held for one year or less are taxed as short-term capital gains. These are generally taxed at the same rate as ordinary income (anywhere from 10% to 37% depending on your taxable income).
However, assets held for longer than one year are taxed as long-term capital gains. Long-term gains are taxed more favorably than short-term gains (anywhere from 0% to 20% depending on your taxable income).
In our previous example, if you are married and file taxes jointly and have $250,000 of taxable income, you are in the 24% federal income tax bracket. If you sold this stock and had owned it for less than one year, you would owe $6,000 on this sale ($25,000 gain x 24% = $6,000 short-term capital gains tax).
However, if you owned it longer than one year, you would owe $3,750 ($25,00 gain x 15% = $3,750 long-term capital gains tax).
As you can see, the IRS looks at long-term gains more favorably than short-term gains. Some taxpayers could even take advantage of being in the 0% long-term capital gains tax bracket. Yes—taxpayers with income under certain amounts can realize long-term capital gains without having to pay a penny.
Do you have any losses to offset the gain?
The fourth consideration when thinking about a potential capital gains tax is whether you have any losses to offset the gain.
Tax-loss harvesting is a strategy that you can take to sell other stocks that have gone down in value. Instead of realizing a gain, you will realize a loss on these assets. Capital losses can offset capital gains of the same type (e.g., a short-term loss can offset a short-term gain).
In our example, if you identified another stock that was down $15,000 in value, you could sell both stocks and only have a net capital gain of $10,000 (as long as the loss and gain are both short-term or both long-term).
Other considerations—inheriting assets and selling your primary house
Inheriting assets allows you to “step up” your cost basis. Imagine inheriting a stock or a house that was purchased years ago. The original cost is likely much lower (if known at all). Current tax law allows you to adjust the cost basis to the fair market value on the decedent’s date of death. This enables you to have a much more manageable taxable gain when you eventually sell the asset.
What about selling your home? When you sell your primary residence, you can exclude a portion of your gain (currently $250,000 for a single tax filer and $500,000 for married taxpayers filing jointly). To put it simply, if you’ve owned and used your house as your primary residence for two out of the prior five years, you might be able to claim the exclusion. This can be complex, so check with a tax advisor to confirm your scenario.
Reporting capital gains tax
Financial institutions will report the sale of securities on a tax form called 1099-B. This form is generated near the beginning of every year for the previous tax year. It will list the assets sold, the date of sale, and the gain or loss for the transaction. If you have a taxable brokerage or mutual fund account, be sure to check with your custodian to see if a 1099 was generated for the previous tax year. Even if you knowingly didn’t sell an asset, there could still be capital gains generated by mutual funds that you own, in addition to interest or dividends reported elsewhere on your 1099.
Consider taxes when making financial decisions
Capital gains tax is one factor to consider when selling an appreciated asset. It’s not the only factor, so don’t let taxes be the proverbial tail that wags the dog. But it can eat into your overall investment return.
If you are in the higher income tax brackets, you should make efforts to minimize capital gains in your investment accounts. At Stewardship, strategies we use with clients include using tax-friendly exchange traded funds (ETF’s), minimizing trading in taxable accounts, harvesting losses, and taking advantage of tax-deferred accounts.
To learn more about tax-efficient investing, schedule an appointment with one of our investment advisors.