You may not even realize that Capital gains taxes are eating into a large percentage of your investment profit unless you actually know how capital gain taxes function. However, if you know how to time your trades correctly and make a couple smart moves, you can legally avoid losing a lot to capital gains taxes. Long-term investors have been using this strategy for decades to preserve their wealth, and rich families have been doing it for centuries through legal means, not “shady ways”.
One of the quickest ways for an investor to make mistakes is by selling their stock too quickly. If you buy an asset (stock, house, etc.) and sell it within one (1) year, the government will treat your income from it as regular income, resulting in a high capital gains tax bill for you.
On the other hand, if you own that same asset for longer than a year, your tax bill drops substantially in many cases. This is not a coincidence; it is a matter of government policy rewarding patience and punishing short-term profits.
Understanding Capital Gains
Capital gains are the dollar difference between the amount you originally paid for an asset and the amount you sell it for. For example, if you purchase a stock for $100 and then sell it for $350, your gain is $250. All of this is just reported as “theoretical” until the day you sell your asset. At that point, you are required to report your gain (you owe taxes on this).
Comparing Short-Term and Long-Term Capital Gains
If you sell your investment after only six months of holding it, you will owe taxes as ordinary income (short-term capital gains). If you are in a high-income bracket, this could be very detrimental to your finances if you have a large amount of capital gains.
But if you hold onto the same investment for more than one year, your sale will be subject to long-term capital gains tax rates, which may be significantly lower and can even be zero for some income levels. So, while the same amount of gain was realized on both sales after six months and one year, the tax consequences are drastically different.
Don’t Forget About Additional Taxes on Capital Gains
Federal taxes are not always the end of your tax liability. Many states have their own tax on capital gains, so be sure to find out if your state has a capital gain (state capital gains tax). In addition to the state capital gain tax, you might also be hit with an additional tax (on high-income earners) on any capital gains realized.
Tax planning is crucial for high earners. For example, tax liability can greatly affect after-tax return on investment (ROI) for high-income earners. Where high-income earners are concerned, taxes are just as important as return on investment (ROI).
When you sell an investment for less than what you’ve paid, you generate a capital loss. The loss is use to offset gains from your profitable investments instead of being taxed as regular income, meaning less tax liability.
If your total capital losses exceed your total capital gains, you may use a portion of your capital loss to offset your ordinary income, and carry over remaining losses into future years.
Tax-Loss Harvesting teaches high-income earners a great approach to save money on their taxes. An investor who has profited from one stock and lost money on a different stock will sell both stocks. This will allow an investor to write off their capital loss against their capital gain, effectively reducing their tax liability, and then reinvest their proceeds back into a similar investment. In this manner, investors will not change their asset allocation, yet, will reduce the amount of taxes they pay to the government.
The following are three of the many capital gains tax loopholes:
- Retirement Accounts: Capital gains taxes do not apply to investments in retirement accounts such as 401(k)s and IRAs; therefore, individuals can buy, sell, and manage these accounts without incurring taxes.
- Primary Residence: If an individual sells their primary residence, considerable profits can be tax-exempt if all other criteria are met.
- Stepped Up Basis: When an individual dies and leaves their assets to their heirs, the cost basis of those assets is stepped up to fair market value. Therefore, heirs can sell the inherited property at fair market value five seconds after they inherit it and will not have to pay capital gains tax on it. This process allows wealth to be passed down without tax implications, generally speaking.
The Real Lesson: In addition to Choosing Quality Assets, Investors Must Have Knowledge of Timing, Holding, and Taxation… and This Has a Huge Impact on Wealth Creation.
Two people make identical investments; they share identical profits; but each walks away with a different result, based solely on whether one of them understood capital gains while the other did not.
If you are serious about building long-term wealth, having this type of knowledge is a requirement (essential) and therefore mandatory.
