The end of the year can be a time for reflection, and that can also apply to your investment accounts. Many people decide to rebalance their portfolios as the end of the year approaches, so it is especially important to understand the effect that your trading actions have on your tax bill coming this April.
Below, you will find three easy-to-apply methods to lower or even eliminate any possible capital gains tax in 2021.
1. Harvesting Tax losses
If you have some losses in your taxable brokerage account, you will be able to offset the losses against any of your gains to keep from having to pay capital gains tax. You will need to net losses and gains of the same kind. For instance, short-term gains could only be netted against your short-term losses, and your long-term gains could only be netted against your long-term losses. From this point, you will again net the total to calculate the final number that will be reported on your tax return.
Let’s illustrate this with a numerical example. Let’s Say you have $5,000 in total short-term losses for the year (i.e., you purchased a stock earlier in the year and have seen it decrease in value by $5,000). During the same time, you have another stock that you bought earlier in the year that has gone up in value by $2,000.
If you were to sell both of these stocks, you would lock in a short-term gain of $2,000 and a short-term loss of $5,000, which leaves you with a $3,000 net short-term capital loss. Fortunately, you would avoid having to pay any tax on the stock that produced a gain, and you would also be able to subtract the $3,000 short-term capital losses as a deduction against ordinary revenue on your tax return.
2. Rebalance within your retirement accounts
When you start to rebalance in your brokerage account, you will pay tax on any gains that are realized. For instance, if you purchased a stock that increased in value and then you sold it after the increase, the IRS would come collecting. However, there is a different outcome if you were to trade in your retirement accounts.
Because some popular retirement vehicles such as Roth IRAs, 403(b)s and 401(k)s are tax-advantaged accounts, you will only owe taxes when you contribute or when you’re on the way out and receive a distribution. This will let you trade freely with your retirement accounts without having a fear of any capital gains tax — long or short term.
If you own a financial plan that calls for semi-yearly rebalancing, it is to your benefit to do the rebalancing in your retirement account where you’re sure there will be no real downside to moving your money around. Understanding this allows you to be even more deliberate when you bring your asset allocation back in line.
3. Do not do anything
Not touching your investments, regardless of how well they have performed, is a great strategy for paying zero capital gains tax. If your investments have appreciated a lot this year (and it is possible they have, with the S&P 500’s 20%+ gain this year), there’s no reason to adjust what’s been working for you, that is unless you need the money now.
Alternatively, you could defer investment sales to next year, which would postpone any potential capital gains tax due until 2023. This is a good strategy if you have a hefty tax bill that’s coming up in April or do not have any other losses this year to offset your gains. Here, you would still owe tax, but you would have the benefit of having a while longer to pay it.
Author: Scott Dowdy