The stock market was on a tear in 2023, which is fantastic for your net worth. The downside might be that you may be sitting on a large amount of capital gains. (To be clear, this is a good problem to have). While often ignored, tax planning is part of being a good investor. Building a tax-efficient investment portfolio is a fabulous way to boost net after-tax returns without taking on more investment risk.
Your 2024 Capital Gains Bill Will Depend On 4 Main Things
1) The Amount Your Investments Have Increased In Value
2) How Long You Held The Investments You Sold
3) Your Total Income From All Sources
4) The Type Of Investments That Had Realized Capital Gains
When you sell an investment from your portfolio (stocks, bonds, mutual funds, ETFs, real estate, cryptocurrency) for more than your cost basis (essentially, what you paid for the investment), your net profits will be taxed as either long-term or short-term capital gains at the federal level. At the state level, your capital gains taxes will depend on your particular state. For example, California taxes capital gains as regular income with a top tax bracket of 13.3%. OUCH! As a Los Angeles-based financial planner, tax planning is even more valuable for my California clients.
How long you have held your investments will play a significant role in the taxation of your capital gains at the federal level. If you have owned the investment you sell for over a year, you will be taxed at long-term capital gains rates. For investments held less than a year, your capital gains will be taxed at the short-term capital gains rates.
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Some Investments Can Be More Tax Efficient Than Others
If you hold mutual funds in a taxable account, you will be surprised when you get hit with phantom income. In any given year, you could lose money while owning a mutual fund and still get hit with capital gains taxes on gains realized by the mutual fund. You can almost think of this as a game of hot potato. When gains are distributed, whoever still holds the fund will get stuck with the tax bill.
In many cases, using an ETF (exchange-traded fund) will provide a more tax-efficient investing process when compared to similar mutual funds. ETFs also typically come with lower internal expense ratios (they cost you less to own).
How Are Long-Term Capital Gains Taxed?
Let's look at how your long-term capital gains on investment will be taxed at the federal level. Generally speaking, long-term capital gains will have favorable (lower) tax treatments when compared to the taxes owed on short-term capital gains. Long-term capital gains are taxed at 0%, 15%, or 20%, depending on a combination of your taxable income and tax-filing status.
Single tax filers can benefit from the zero percent capital gains rate if they have an income below $47,025 in 2024. Most single people with investments will fall into the 15% capital gains rate, which applies to incomes between $47,026 and $518,900. Single filers with incomes over $518,900 will get hit with the 20% long-term capital gains rate.
The brackets are a tiny bit bigger for married couples who file their taxes jointly, but most will see their investment income hit by the marriage tax penalty. Married couples with a joint income of $94,050 or less remain in the 0% capital gains tax bracket, allowing you to earn tax-free income on your investments. Who doesn't love tax-free income? However, married couples who make a combined total between $94,051 and $583,750 will have a capital gains rate of 15%. Those with combined incomes above $583,750 will get hit with a 20% long-term capital gains rate.
You may also owe taxes on your investment at the state level. If your income is large enough, you may also get smacked by the Medicare surtax.
Dreaded Medicare Surtax On Capital Gains Income
I say the dreaded Medicare surtax because it is often a surprise the first time someone has to pay it. In many cases, it usually comes up when someone has a big spike in their income. For example, they receive a large amount of equity compensation or sell a home.
When your income exceeds certain thresholds, you may owe additional taxes on your investment income. For example, married taxpayers with incomes of more than $250,000 will also be required to pay an additional 3.8% net investment surtax. (The Medicare surtax applies to incomes above $200,000 for single filers.) This Medicare surtax applies to all investment income regardless of whether the capital gains are long-term or short-term. This threshold is not pegged to inflation, so more taxpayers can expect to get hit with the Net Investment Income Tax (NIIT) each year.
Short-Term Capital Gains Rates For 2024
If you end up with short-term capital gains, they will usually be taxed at your regular income-tax rates. This happens when you hold an investment for less than one year and then sell it. From a tax-planning perspective, the good news is that up to $3,000 of short-term losses can be deducted against regular income each year. That provides a great opportunity to lower your taxes with tax-loss harvesting.
Taxes On Investment Gains In Retirement Accounts
The gains on your investments held in your 401(k), traditional IRA, Defined-Benefit Pension Plan, 403(b), and tax-sheltered annuities (TSA) will be tax-deferred. You will only owe taxes on the gains in your retirement accounts once you make a withdrawal. If you have a Roth 401(k) or Roth IRA, your withdrawal will be tax-free, assuming you follow Internal Revenue Service (IRS) rules.
The year 2024 brings new contribution limits to these retirement plans, so consider increasing your contributions for 2024.
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Taxation Of Capital Gains On Real Estate
There are some big tax advantages when selling real estate, specifically your primary residence. When you sell your home (primary residence), you may be able to avoid paying a substantial amount of taxes on your gains. In many parts of the country, you may not owe any capital gains taxes when selling your primary residence.
Single homeowners (unmarried) may be able to exclude up to $250,000 in capital gains on the sale of their primary residence. This number doubles to $500,000 for a married couple selling their primary home. You must follow a few rules to get this large tax break; most notably, you must have lived in your primary residence for at least two of the past five years.
Remember that the taxable gain is based on the cost basis of your home, which is likely not the same number as the original purchase price of your home. So, keep track of all your home improvements or remodeling projects over the years. Even things like a new water heater or roof can increase the cost basis of your home. The higher your cost basis, the smaller your tax bill will be once you sell your home. For example, if you purchase a McMansion in West Hollywood for $5 million and then spend $1.5 million remodeling it, you will have a cost basis of $6.5 million. If you are married and have lived there for two of the past five years, you could sell it for $7 million without having to pay any capital gains taxes on the sale.
The tax rules are slightly different for investment properties. You will owe capital gains taxes on the net profit from the sale, but you will also owe gains on the cumulative depreciation benefits you have received while you owned the property. That process is known as depreciation recapture. It is a topic too complicated to discuss here completely. I need you to be aware that on investment properties, your cost basis is likely less than you put into the property. Before selling your investment property, talk with your certified financial planner and CPA to ensure you understand the tax consequences. If you are selling one property to buy another, you may be able to defer taxation with a 1031 exchange.
Should You Avoid Short-Term Capital Gains In 2024?
Tax drag should only be part of the equation when deciding whether to buy or sell investments. This process is even more important if you are trading individual stocks. When buying or selling an investment, you should know how long you have held the investment and what taxes are due when you sell. In many cases, especially if you are close to having held the investment for a year, you will want to try to avoid getting hit with short-term capital gains.
The IRS tax code encourages long-term investing or holding an investment for at least a year. In most cases, long-term capital gains rates will be lower than your earned income-tax rates.
Reducing the tax drag on your investment can help increase your net after-tax investment returns. Work with your tax-planning financial planner and CPA to ensure you invest in the most tax-efficient manner and avoid paying unnecessary taxes.
Introduction
As an expert in tax planning and investment strategies, I can provide you with valuable insights on the concepts discussed in the article you shared. My expertise in this field is based on extensive knowledge and experience in financial planning, tax optimization, and investment management.
Concepts Discussed in the Article
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Tax Planning: Tax planning is an essential aspect of being a good investor. It involves strategies to minimize tax liabilities and maximize after-tax returns. By building a tax-efficient investment portfolio, you can boost your net after-tax returns without taking on additional investment risk.
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Capital Gains: Capital gains are the profits realized from the sale of investments such as stocks, bonds, mutual funds, ETFs, real estate, and cryptocurrency. When you sell an investment for more than your cost basis (the amount you paid for the investment), the net profits are subject to capital gains tax.
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Long-Term vs. Short-Term Capital Gains: The duration for which you hold your investments plays a significant role in the taxation of capital gains. If you hold an investment for more than a year before selling, the gains are considered long-term capital gains and are taxed at lower rates. On the other hand, if you sell an investment held for less than a year, the gains are classified as short-term capital gains and taxed at your regular income tax rates.
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Tax Rates for Long-Term Capital Gains: Long-term capital gains are taxed at different rates depending on your taxable income and filing status. The tax rates for long-term capital gains are generally lower than those for short-term capital gains. The rates range from 0% to 20%, with different thresholds for single filers and married couples filing jointly.
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Tax Rates for Short-Term Capital Gains: Short-term capital gains are taxed at your regular income tax rates. If you hold an investment for less than a year before selling, the gains will be subject to the same tax rates as your other income. However, you can deduct up to $3,000 of short-term losses against your regular income each year, which can help lower your overall tax liability.
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Taxation of Investment Gains in Retirement Accounts: The gains on investments held in retirement accounts such as 401(k)s, traditional IRAs, and Roth IRAs are tax-deferred. You will only owe taxes on the gains when you make withdrawals from these accounts. Roth accounts offer the advantage of tax-free withdrawals if you meet the IRS rules.
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Taxation of Capital Gains on Real Estate: Selling real estate, particularly your primary residence, can have significant tax advantages. Homeowners may be able to exclude a portion of their capital gains from taxation, depending on certain criteria. The rules for excluding capital gains on the sale of a primary residence include a minimum residency requirement and keeping track of home improvements to increase the cost basis.
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Medicare Surtax: The Medicare surtax is an additional tax imposed on investment income for high-income individuals. When your income exceeds certain thresholds, you may owe an additional 3.8% net investment surtax. This surtax applies to all investment income, regardless of whether the capital gains are long-term or short-term.
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Tax Efficiency of Different Investments: Some investments, such as ETFs (exchange-traded funds), can be more tax-efficient compared to similar mutual funds. ETFs often have lower internal expense ratios and can help minimize tax liabilities, especially in taxable accounts.
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Tax-Loss Harvesting: Tax-loss harvesting is a strategy that involves selling investments at a loss to offset capital gains and reduce tax liabilities. Up to $3,000 of short-term losses can be deducted against regular income each year, providing an opportunity to lower taxes.
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Tax Consequences of Investment Property: Selling investment properties can have different tax consequences compared to selling a primary residence. Capital gains taxes are owed on the net profit from the sale of an investment property, and there may also be depreciation recapture. It is important to consult with a certified financial planner and CPA to understand the tax implications before selling an investment property.
Conclusion
Understanding the concepts of tax planning, capital gains, tax rates, and tax-efficient investments is crucial for maximizing after-tax returns and minimizing tax liabilities. By implementing effective tax strategies and working with financial professionals, you can optimize your investment portfolio and make informed decisions to achieve your financial goals.
