In retirement, capital gains can have a major impact on your total tax bill because they do increase your adjusted gross income (AGI).
In this article, you will learn:
- What are capital gains?
- How does the IRS determine your capital gains taxes?
- How capital gains affect your taxes?
- Smart Tax Planning for Capital Gains
WHAT ARE CAPITAL GAINS?
Over time, you've likely accumulated capital assets such as stocks, bonds, or real estate. A capital gain occurs when you sell a capital asset for a value higher than the purchase price in a non-retirement account. A few reasons people sell assets that have capital gains range from needing cash, distributions for retirement, to diversify, or they may sell just because the asset has been underperforming.
Whatever the case, you should understand how capital gains affect your tax burden. Notably, you only pay taxes on an asset once you sell it and "realize gains". You're not required to pay taxes on "unrealized gains" no matter how long you hold an asset.
HOW DOES THE IRS DETERMINE YOUR CAPITAL GAINS TAXES?
Taxes on capital gains are a type of investment income tax. You are legally required to pay taxes on the profits you make after selling a capital asset. Your taxes depend on:
- What you paid for an investment
- Your taxable income
- The length of your investment (short-term or long-term)
The Length of Your Investment
Capital gains are categorized into two major groups: short-term and long-term.
- Short-term capital gains occur when you sell an asset you've held for less than one year for a profit. The taxes on these gains are paid based on ordinary income tax rates.
- Long-term capital gain taxes are taxes paid on profits from the sale of assets held for more than one year. The tax rate on long-term capital gains varies from 0%, 15%, and 20%, depending on your taxable income. Generally, tax rates on long-term capital gains are lower, and as such, more investors choose to hold assets longer than one year before selling.
HOW CAPITAL GAINS AFFECT YOUR TAXES
Short-term and long-term capital gains increase your adjusted gross income (AGI). An increase in AGI can phase you out of some tax credits, affect your eligibility for certain retirement contributions, and your eligibility for certain government benefits or programs.
Ordinary income, which includes short-term capital gains, is taxed first at ordinary tax rates. Ordinary tax rates range from 10% up to 37%.
After the ordinary income is taxed, the long-term capital gain portion is taxed at the capital gains rate (0%, 15%, 20%).This means that long-term capital gains will not push your ordinary income into a higher tax bracket.
In 2022, if you are single and earn less than $41,675 or are married filing jointly and earn less than $83,350, you could pay 0% taxes on your long-term capital gains up to each of those respective thresholds. Any capital gains that increase your taxable income over those dollar thresholds get taxed at 15%.
As a little FYI, the 15% capital gains tax rate bracket is large. It goes from $41,675 to $459,750 for individuals and from $83,350 to $517,200 for married couples. After those amounts the long-term capital gains tax rate moves to 20%.
Roth IRA Conversions
A discussion on retirement tax planning would be incomplete without mentioning Roth IRAs and Roth IRA Conversions.
Generally, you'll want to analyze the tax implications of converting traditional IRA money to a Roth IRA for the year of the conversion and future tax years. For instance, you don't want to pay more taxes on the conversion than you would have by not converting.
So, where do capital gains factor in? Short-term capital gains can raise your ordinary income tax rate. Traditional IRA distributions are taxed at your ordinary tax rate. In years where you want to do a Roth conversion, you should forgo realizing short-term capital gains if your ordinary income would be greatly increased.
If you are considering doing a Roth conversion and realizing long term capital gains in that year, it is important to remember that the Roth conversion will increase your ordinary income tax and could potentially land you in a larger capital gains tax bracket as well. When doing a Roth conversion in any year, it is usually prudent to minimize the amount of realized capital gains in that year. If realizing capital gains is necessary or unavoidable, then it may be prudent to forgo or reduce the amount of your Roth IRA conversion.
Capital Gains on Real Estate
You may be required to pay taxes on your primary residence if sold for a large gain. Currently, the IRS allows taxpayers to exclude up to $500,000 in capital gains on a primary residence if married filing jointly or $250,000 if single. Gains above the exclusion amount would be taxed.
However, the exemption isn’t applicable if:
- The home sold wasn't your principal residence
- You owned the home for less than two years within the five-year period before the sale
- You didn't reside in the property for at least two years in the five-year period before the sale
- You've already claimed the capital gains exclusion from the sale of a property within the two-year period before the sale of this other home
- You bought the property through a 1031 exchange
There are exceptions to these rules, such as military provisions. As always, it is important to talk your tax preparer about your specific situation.
SMART TAX PLANNING FOR CAPITAL GAINS
There are several ways to lower your tax burden while enjoying capital gains from your assets.
Check Your Holding Period
The holding period for an asset determines whether you pay short-term or long-term capital gains taxes. Generally, long-term gains are more favorable than short-term gains. So before selling any of your stocks, collectibles, or investment accounts, try and hold out for one year if possible.
Record Your Losses
While gains are worth noting, losses are equally important. Always keep records of any capital losses (when you sell an asset for a value lower than the purchase price).
You can use capital losses to offset your capital gains for a tax year, allowing you to reduce your taxes for the year. If you don't have capital gains, you can use capital losses to reduce your ordinary taxable income and lower your tax bill.
For example, if you made $4,000 in capital gains but had $3,000 in capital losses, you only pay taxes on the net difference, $1,000, between the two amounts. However, if you have no gains and made $3000 in capital losses, you can subtract up to $3,000 from your total income to reduce your total tax bills.
The maximum amount of losses deductible varies depending on your filing status. For example, for individual taxpayers or married and filing jointly status, you can deduct $3,000 in 2022. However, for married couples filing separately, the IRS allows a maximum deduction of $1,500.
So, what happens if you incur a huge loss and cannot deduct the total amount for one tax year? Fortunately, you can carry the loss forward into other tax years and apply the maximum capital loss deductible each year. The general rule to remember is to keep records for the IRS.
There is one other important item to note when it comes to selling investments to harvesting tax losses. If you purchase the same or "substantially identical" investment 30 days before or after selling for a loss, you are unable to recognize the loss on your taxes for that year. This is known as the wash-sale rule.
Both long-term and short-term capital gains are taxable. However, the taxes you end up paying depends on multiple factors. Working with a qualified tax planning expert who knows the tax-code and associated financial tools can lead to many tax planning opportunities when it comes to capital gains.
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