The U.S. stock market continues to reach new highs, and many investors are using this opportunity to take gains. Yet cashing out also comes at a cost if you invest outside of qualified investment accounts. Indeed, most investors understand that selling their assets for a profit triggers the capital gains tax. Simple enough. What’s less straightforward is how capital gains may affect your tax bracket. In this article, we’re breaking down everything you need to know about capital gains. Plus, we’ll share a few tax planning strategies to help you minimize your overall tax bill this year.
What Is a Capital Gain?
A capital gain is the profit an investor earns on the sale of an asset that’s increased in value over its holding period. Generally, if you hold an asset for more than one year before selling it, your capital gain is long-term. On the other hand, your capital gain is short-term if you hold it one year or less.
Investors may take capital gains for a variety of reasons. For example, you may be unwinding a large stock position that’s appreciated significantly in value. Or perhaps you’re retired and need the income for a large purchase or daily living expenses. Regardless of the reason, realizing capital gains is a taxable event.
How Are Capital Gains Taxed?
Currently, long-term capital gains on investments have lower tax rates than ordinary income. In 2021, the long-term capital gains tax rate for most investors is 15%. For high earners—individuals who earn more than $445,851 in 2021—the long-term tax rate increases to 20%. In addition, individuals with significant investment income may be subject to the net investment income tax (currently 3.8%).
That means in a given tax year, the highest rate an investor might pay on long-term capital gains is 23.8% at the federal level–with a few exceptions. However, certain tax planning strategies allow you to offset capital gains with capital losses to reduce your overall tax liability (more on that later).
Capital Gains vs. Ordinary Income: Why Holding Period Matters
The first thing you need to know is that capital gains increase your adjusted gross income (AGI). The IRS defines AGI as gross income minus specific deductions, such as educator expenses and contributions to qualified retirement accounts. Gross income includes wages, dividends, capital gains, business income, and retirement distributions, along with some other types of income.
The bad news is that as your AGI increases, the IRS disallows certain deductions and credits. In addition, you may lose your eligibility to deduct IRA contributions or contribute to a Roth IRA.
Moreover, short-term capital gains are part of ordinary income. That means if you sell an asset after holding it for a year or less, the capital gain can potentially push you into a higher tax bracket.
But there’s good news. Long-term capital gains are taxed separately from ordinary income. And since ordinary income is taxed first, long-term capital gains won’t push you into a higher tax bracket.
In other words, your holding period matters. If you hold an investment for more than a year, selling it for a profit won’t cause your ordinary income to be taxed at a higher rate. In addition, realizing long-term capital gains may allow you to take advantage of a variety of unique tax planning strategies.
Tax Planning Strategies for Long-Term Investors
Fortunately, the U.S. tax code offers some interesting opportunities to reduce your tax burden. As you look for ways to lower your overall tax bill, consider the following tax planning strategies.
0% Cap Gains Rate
You may not realize that the long-term capital gains tax rate is 0% for some taxpayers. In 2021, individuals earning $40,400 or less and married couples filing jointly earning $80,800 or less pay a 0% long-term capital gains rate. These earnings thresholds increase to $41,675 and $83,350, respectively, in 2022.
If you exceed the earnings threshold, there may be ways to lower your taxable income enough to fall within the 0% bracket. For example, you may be able to make additional retirement plan contributions or take advantage of certain deductions if you itemize.
Roth IRA Conversions
The IRS allows individuals to convert a traditional IRA to a Roth IRA–regardless of income–through a strategy called a backdoor Roth IRA. A Roth IRA conversion shifts your tax liability to the present, so you can avoid paying taxes on withdrawals in the future.
With a backdoor Roth, you pay taxes on the amount you convert at your current ordinary income tax rate. Then, any withdrawals you make in retirement will be tax-free if you’re over age 59 ½ and satisfy the five-year rule.
A Roth IRA conversion can be a powerful tax planning strategy, but it doesn’t make sense for everyone. You should consider the advantages and drawbacks before converting your IRA to a Roth.
That said, realizing long-term capital gains in the same year you convert to a Roth IRA can actually reduce your lifetime tax burden. For example, you may have recently retired and therefore have no earned income this year. That means you can convert up to $100,000 from your traditional IRA to a Roth while staying in the 10% and 12% tax brackets (after taking deductions).
Meanwhile, you can take long-term capital gains from your investments to pay your living expenses. You won’t be able to take advantage of the 0% long-term capital gains rate because of the Roth conversion. However, the tradeoff is your $100,000 (minus taxes) can continue to grow tax-free within the Roth IRA indefinitely.
Other Tax Planning Strategies
If you’re simply looking to reduce the taxes you owe on capital gains, tax-loss harvesting can be a beneficial tax planning strategy. Tax-loss harvesting involves selling investments at a loss to offset gains, thereby lowering your capital gains tax liability. If you work with a fiduciary financial advisor like Milestone Asset Management, they likely do this for you.
Capital Gains & Social Security Benefits
Those collecting Social Security benefits should pay careful attention to capital gains when evaluating tax planning strategies. In fact, capital gains and Social Security benefit taxes have a circularly relationship.
The Social Security Administration announced a 5.9% cost-of-living adjustment (COLA) for 2022. Depending on your other retirement income sources, this atypical boost to your benefits could potentially push you into a higher tax bracket for ordinary income and capital gains.
At the same time, mismanaging your capital gains can change how your Social Security benefits are taxed. If your capital gains and income from other sources are low enough, your Social Security benefits may not be taxable. However, if your income exceeds that threshold due to large capital gains, your benefits may become taxable. In other words, without proper planning, you may end up paying a higher marginal tax rate on your income in retirement.
Bottom Line: Capital Gains Won’t Push You into a Higher Tax Bracket—But They May Affect Your Financial Plan
There are a variety of tax planning strategies you can leverage to reduce your tax bill, particularly in years when your earned income is below average. Just remember, these strategies can be complex and often come with opportunity costs. It’s best to consult your CPA or financial planner to determine the options that make the most sense within the context of your overall financial plan.
As tax planning advisors, Milestone Asset Management Group works directly with our clients to help them minimize their tax burden. In addition, we have a full suite of CPAs and tax attorneys to help us stay up to date on current tax laws. If you’d like to speak with a fiduciary financial advisor about investment and tax planning opportunities, please schedule a call.