This is a guest post from Eric Rosenberg, a finance writer at Personal Profitability, InvestmentZen, and other personal finance, technology, and travel publications.
In many cases, investment gains are measured in terms of small percentage gains. But just because you earned a gain on an investment doesn’t mean you get to keep it all. Outside of some special rules for retirement, healthcare, and college savings accounts, you have to pay taxes on your investment gain. With real dollars at stake, it is important to understand how investment taxes work before you get hit with a surprise bill. Read on to learn how it works and how you can plan for capital gains taxes.
Taxes on investment gains
When you invest, some investments may go up and others go down. When you earn a profit while investing, it is called a capital gain, and is taxed under rules called the capital gains tax. Prior to the Affordable Care Act, capital gains taxes were a little simpler. Today, there are tiers of capital gains taxes depending on your overall income and the age of investments when you sell and recognize a gain.
If you are single and earn up to $37,950 per year or married and earn up to $75,900 in combined household income, you don’t have to pay any taxes on long-term capital gains. Long-term is defined as an investment you owned for one year or longer. Above those income levels, the long-term capital gains tax rate is 15% up to $418,400 in annual income when single or $470,700 when married. If your income is above that, I’m jealous! But that also means you fall into the highest capital gains tax bracket of 20%.
In most cases, short-term capital gains are taxed at your regular income tax level. For example, a married family filing jointly earning a combined $70,000 per year falls into the 15% tax bracket. Short-term gains would be taxed at 15% for this family, while long-term capital gains would require no capital gains tax.
Because most families earn less than $75,900 per year, most families would pay no long-term capital gains tax. The remaining 38% of the population falls into the 15% or 20% category.
Capital Losses and Tax loss harvesting
If you do fall into an income range where you owe capital gains taxes, you have some options to save on taxes. The two most common options for most investors include capital losses and tax loss harvesting.
The IRS understands that some investments lead to profits and others lead to losses. Rather than charging taxes on gains and ignoring losses, tax regulations allow you to offset capital gains with capital losses. For example, if you have one stock investment that earns $10,000 in one year and another loses $8,000, you would have a $2,000 net gain and only have to pay taxes on the $2,000 profit.
This is a simplified version of opportunities to lower taxes through a process known as tax loss harvesting. With tax loss harvesting, investors can sell investments with a loss and re-buy a similar investment to capture the loss for tax purposes. Capital losses can accumulate and carry over from year-to-year, so capturing a loss this year can offset a capital gain next year.
Manual tax loss harvesting is possible, but far from simple. The best results from tax loss harvesting require a computer. Robo-advisors like Betterment and Wealthfront stand out from other investment apps because they make tax loss harvesting automatic. With automated robots handling this behind the scenes, you can capture more tax losses to offset capital gains.
Retirement and other tax advantaged accounts
But wait, there’s more! The tax rules above only apply to regular old investment accounts. These accounts are considered taxable, as there is no protection from capital gains taxes when investing in a standard investment account. There are other accounts, often offered by the same brokerages, that offer a tax advantage over a regular taxable investment account.
Some accounts shield you from taxation as long as your cash and investments remain in the account. Some account contributions are considered pre-tax and others are considered post-tax contributions. Here’s how they work:
Pre-tax contributions are made in accounts like a 401(k) through your employer or a traditional IRA at your brokerage. In these accounts, you do not pay any income taxes on the contributions you make to the account in the year you earn the income. Then, you can invest and watch your investments grow for decades without paying any taxes. When you withdraw during retirement, withdrawals are taxed at your new income tax rate, with is presumably lower in retirement than when you were working full-time.
Post-tax contributions are made in accounts like a Roth IRA or Roth designated 401(k). In this case, you pay income taxes on your contributions, but do not pay any taxes on capital gains or withdrawals in retirement. This type of account is best for younger investors with a long-time horizon before retirement.
Retirement accounts are the most common tax advantaged accounts, but they are not the only option. 529 college savings accounts offer similar rules to pre-tax accounts like a traditional IRA. Healthcare focused HSA accounts offer both tax free contributions and withdrawals, which is the best of both! With these accounts, you can plan better for capital gains taxes, as some are tax-free and others offer a very long-time frame before taxes kick in during retirement.
Plan for taxes but don’t let them dictate your investments
I was once discussing taxes with a friend who insinuated that people would want to earn less as tax rates increase. That is a ridiculous idea! I would rather earn an extra dollar and give 40% to the government than not earn the dollar at all! The same is true of capital gains taxes.
While taking advantage of legal strategies to lower your tax bill is a wise financial decision, taxes should not scare you off from investing or dictate your investment decisions. The only time I have let taxes change an investment decision was when I was just a few weeks away from turning a short-term gain into a long-term gain, lowering my taxes on that specific gain on an investment I already had. I have never bought or sold investments just for tax reasons, and most people that don’t have many millions invested are typically best off doing the same.
If you hit a hot investment that brings you hundreds or thousands of dollars in gains, it is a time to celebrate. Sure, you’ll pay a portion of that gain in taxes, but you get to keep at least 80%. With so much to gain from investing, do not let taxes scare you away. You have much more to gain than to lose, and paying capital gains taxes is proof of a winning strategy.
The next time you see an article with a scary headline about capital gains taxes, don’t let it cloud your judgement on investment decisions. Investments should be focused on a long-term strategy to grow your wealth over time. Taxes are a part of the equation, but are far from an obstacle to success.