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February 7, 2024

Are Your Investments Optimized For Capital Gains Tax?

by Team Rowling

Investing in diversified assets is one of the most feasible options you have to improve your financial health and build wealth. As far as investment assets are concerned, you can allocate capital to a variety of assets, such as stocks, bonds, index funds, and more. These assets can help you generate passive income in the form of dividends and returns.

As they increase in value, they can also be sold for a greater price than what you initially paid for them to generate substantial profits. However, the sale of such assets can incur capital gains tax, which can reduce the actual amount of money you earn. Therefore, it’s important that you consider whether your investments are optimized for capital gains tax.

In this article, we’ll understand what capital gains tax is, which investment vehicles it applies to, and how you can determine if your investments are optimized for taxes.

Capital Gains and Losses

Understanding Capital Gains Tax

Capital gains tax is what you have to pay when you generate profits from the sale of an investment asset. This tax is owed for the tax year in which the investment is sold and is divided into two types: short-term and long-term capital gains tax. The classification of a capital gains tax is one of the two categories depending on the duration.

To make your investments tax efficient, it’s essential for you to know that if you hold an investment asset for less than one year, your earnings will be subject to short-term capital gains tax. However, if you sell it after holding on to it for longer than one year, your earnings will be subject to long-term capital gains tax.

Capital Gains Tax Rate

These tax rates are applied based on the net capital gains. However, it’s important for you to know that your net capital gains are the amount by which your net long-term capital gains exceed your net short-term capital gains. In addition, the rate for net capital gains also varies based on your overall taxable income.

Depending on these variations, it’s possible that some net capital gains may be taxed at 0%. Your capital gains would be subject to these tax rates if your overall taxable income is within the following tax brackets:

  • $44,625 for individuals who are single or married but are filing separately.
  • $89,250 for those who are married and filing for a qualifying surviving spouse.
  • $59,750 for those who are the head of the household.

However, you may have to pay a capital gains tax of 15% to 20% or more based on your income. Therefore, it’s important to be aware of your tax bracket and know whether your investments are tax-efficient.

Optimizing Investments For Capital Gains

When investing, it’s important to understand that capital gains tax can greatly reduce your take-home profits. However, there are various strategies that can help you optimize your investment for capital gains. Some of these strategies include:

1.     Asset Locations

One of the most effective ways to optimize your investments for capital gains tax is to allocate them to different accounts that have certain tax benefits. An individual retirement account (IRA), Health Savings Account (HSA), and 401(k) plans are all great examples of retirements that allow your investment to grow tax-free.

You can use these accounts to minimize your taxable income, which would ultimately reduce the amount of capital gains tax you would have to pay. However, you shouldn’t keep all your investments in tax advantage accounts to ensure portfolio diversification. It’s better to use such accounts for high-return investments.

2.     Harvest Losses

The ideal aim of investing is to sell assets at a price higher than what they were acquired at in order to generate income. However, it’s important to know that selling an asset at a lower price can help reduce capital gains tax. This approach can be suitable if you have made significant gains on one asset.

In this case, you may decide to hold onto the income-producing investment asset and sell a different one for less money. Doing so can help minimize your net capital gains, thus reducing your capital gains tax rate. Working with a wealth management firm can help you leverage market fluctuations and capitalize on losses.

3.     Know Your Tax Bracket

As mentioned, capital gains tax varies based on the income tax bracket you’re in. However, it’s important to realize that you can use this information to minimize capital gains tax. To use this approach, you must be aware of where you are in your tax bracket.

If you’re at the lower end of the bracket, you could essentially realize your capital gains and yet be taxed at the same rate. However, if you’re towards the higher end of the bracket, it’s better not to incur capital gains, as doing so would mean you move into the next tax bracket and are taxed at a higher rate.

4.     Securities Based Lending

This approach to optimizing capital gains tax is suitable for those who have a taxable brokerage account. The idea behind the approach is to use the securities, resulting in a capital gains tax, as collateral to back a line of credit. With this approach, you won’t realize any capital gain and won’t be taxed.

In addition, you won’t have to liquidate your investments and sustain any gains or losses to access cash. However, it’s important to remember that if your investments’ value decreases, you must add additional securities to the account to replenish its value. This line of credit cannot be used to buy additional securities.

Key Takeaway

Investing in multiple assets helps to build wealth and achieve financial freedom. However, it’s also important to remember that capital gain incurred on investment assets can reduce your net profit amount. Therefore, you must ensure that your investments are optimized for capital gains tax.

To do this, focus on strategically placing your assets in a tax advantage account, harvesting losses, and leveraging securities-based lending. Doing so will help you minimize capital gains in any given tax year, reducing the tax you have to pay.

Does your wealth management firm optimize for taxes? At Rowling & Associates, we believe investing should be tax efficient. Visit our Tax Efficient Investing page and read additional articles about tax planning to learn more about our investment services and planning your taxes effectively. As always, please contact us if we can be of support for any of your wealth management needs.

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