Today I am going to discuss capital gains tax and how it affects your taxes in retirement.
Classic investments, like stocks and bonds, are not the only investments that incur capital gains. These taxes can apply to any other "capital asset" that acquires value over time.
In retirement, you should understand how capital gains or losses affect your tax return. Your total taxable income can increase or decrease substantially depending on the investment type and the total investment gain or loss.
What You Will Learn:
- What is a capital gain
- Short term vs long-term capital gain
- How capital gain will affect your retirement accounts
- 4 Ways to minimize capital gains taxes
- What isn't affected by capital gains
WHAT IS A CAPITAL GAIN?
A capital asset sale or exchange can result in a gain or a loss. A capital gain occurs when you sell the asset at a higher price than the basis of that particular asset. The basis refers to the buying price plus commissions and costs of improvement minus depreciation.
A capital loss occurs when the asset is sold at a price that is less than the basis.
Capital gain is an increase in the value of a capital asset. Say, for instance, you buy a stock at a given price, and later, say one or more years down the line, you sell it at a higher price than you purchased it for. This would produce a capital gain.
SHORT-TERM VS. LONG-TERM CAPITAL GAIN
When you sell an asset, it can either be short-term or long-term capital gain. Short-term capital gain is when you owned it for one year or less, while long-term is more than one year. The reason why this distinction is important is that capital gains are taxed according to the holding period, which is the length of time you have held a given asset.
Different rules and tax rates are applied to short and long-term capital gains, but generally, long-term capital gains are taxed at a lower rate compared to short-term capital gains.
Typically, short-term capital gains do not benefit from any exemptions and have the same tax rate as ordinary income. This tax rate depends on your taxable income and filing status and can range from 10% to 37% as shown in the table below.
It is also important to note that the holding period starts the very day that you acquired the asset and ends the day you dispose of it.
2020 Short-Term vs Long-Term Capital Gains Tax Rates
Some assets are exempt from long-term gain taxes! These assets include collectibles such as coins, valuable vintages, fine arts, and antiques. Any gains from the sale of these items will be taxed at the rate of 28% regardless of the holding period.
Occasionally, a surtax of 3.8% may also apply. It is called the net investment tax. This surtax applies once your taxable income exceeds a certain threshold.
HOW WILL A CAPITAL GAIN AFFECT YOUR RETIREMENT ACCOUNT
There are no capital gain taxes inside a retirement account. Your retirement accounts have pretax money invested in them. You are free to buy and sell without generating long-term or short-term capital gain from your retirement account.
However, once you withdraw money from your retirement account everything is taxable as ordinary income.
3 WAYS TO MINIMIZE CAPITAL GAINS TAXES
1. Tax Loss Harvesting
The way you manage your portfolio can influence the way capital gains affect your returns. For example, you can use capital losses to offset a part of capital gains taxes in other stocks. To illustrate this, let’s use an example where you had a gain of $3000 after selling stock X, but experienced a loss of $1800 upon the sale of stock Y.
You can use the loss in stock Y to offset the gain in stock X. The net capital gain would only be $1200 because the loss offsets the gain.
People who have built up capital gains need to offset the gains with losses. If there is an excess, you can carry it over to the following year until you exhaust it. Monitor the hold times of your investments, so you don't dispose of them too early.
As earlier noted, the holding time will affect the tax rates applicable to your gains.
2. Annuities and life insurance
Another way of softening the capital gain tax effect is by using an annuity or life insurance policy. Annuities such as variable annuities offer market exposure to people who wish to benefit from investments with gains above the interest rate or fixed investments with guaranteed amounts in other annuities.
A person looking for a tax deferral in the future will find a variable annuity shell convenient for the movement of investment without paying taxes in the year where change occurs.
Additionally, investors with variable annuities can defer taxes on capital gain until the investment will be paid out as income. This also applies to some types of permanent life insurance policies that offer income replacement to the beneficiary upon the death of the policy owner on top of offering tax deferrals.
Any money that is taken or borrowed from the cash value is not subjected to taxes.
3. Like-Kind Exchanges
A 1031 Exchange is an exchange of like-kind properties in the United States. Put simply, a property being sold is not subject to capital gains tax until it is eventually sold without reinvestment of the proceeds.
Essentially, this allows not for the avoidance, but the deference of any taxable gains on the property that is first sold.
Capital gains taxes can be deferred by investing gains in like-kind assets. However, make sure to consult the IRS website or your tax professional before moving forward on any like-kind exchange, as the requirements and investment types have changed over the years.
Whenever selling an investment, or even a piece of property, make sure to consult a tax advisor or IRS representative to help determine how much you could be taxed.
WHAT ISN'T AFFECTED BY CAPITAL GAINS?
Certain types of property and accounts are not affected by capital gains taxes. If applicable, see if you can utilize these property or account types to maximize your investment.
First, anything you create as an individual is exempt. This could be a book you wrote or an invention you patent.
Second, waiting before selling your home can reduce the amount of taxes you pay. If you own a house and have used it as a principal residence for at least two of the five years before selling, the capital gain will be excluded up to a maximum of $250,000 if you are single and $500,000 if you are married.
These days, tax rates and tax planning have become much more complicated. Understanding how capital gains tax affects your tax rate in retirement will have a major impact on your overall financial plan.
Knowing how you can maximize deductions and reduce your taxes will eventually lead to an overall greater amount of income in retirement.