Although the stock market had a rough year in 2022, many long-term investors still have substantial capital gains on their taxable investments. Many projections for 2023 point to some positive stock market returns. If nothing else, expect more volatility throughout the year. While often ignored, tax planning is part of being a good investor. Being tax efficient with your investments is a great way to boost net after returns without needing to take on riskier investments.
Your Capital Gains Bill with Depend on Four Main Things
1) How much the value of your investments has increased
2) How long have you held your investments
3) Your overall income from all sources
4) The type of investments you hold
When you sell an investment (stocks, bonds, mutual funds, ETFs, real estate, cryptocurrency) for more than your cost basis (essentially, what you paid for the investment), your net profit will be taxed as either a long-term or short-term capital gain at the federal level. At the state level, your capital gains taxes due will depend on your particular state. For example, California taxes capital gains like regular income with a top tax bracket of 13.3% at the state level. OUCH! As a financial planner in Los Angeles, tax planning is even more valuable for my local clients.
How long you have held your investments will play a significant role in the taxation of your capital gains. If you have owned the investment you are selling for more than one 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.
Some Investments Are More Tax Efficient Than Others
If you hold mutual funds in a taxable account, you may get hit with phantom income. In a given year, you may lose money while owning a mutual fund and still owe taxes on realized gains realized by the fund. You can almost think of this as playing hot potato. Whoever still holds the fund when gains are distributed will get stuck with the tax bill.
In many cases, using an ETF (exchange-traded funds) will provide a more tax-efficient investing process.
Let’s look at how your long-term capital gains on investment will actually be taxed at the federal level. Generally, 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 the rate of 0%, 15%, or 20%, depending on a combination of your taxable income and marital status.
For single tax filers, you can benefit from the zero percent capital gains rate if you have an income below $44,625 in 2023. Most single people with investments will fall into the 15% capital gains rate, which applies to incomes between $44,625 and $492,300. Single filers with incomes more than $492,300 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 $89,250 or less remain in the 0% tax bracket, which is excellent news. Who doesn’t love tax-free income? However, married couples who earn a combined total between $89,250 and $553,850 will have a capital gains rate of 15%. Those with combined incomes above $553,850 will get hit with a 20% long-term capital gains rate.
You may also owe taxes at the state level, and if your income is large enough, you may also get smacked by the Medicare surtax.
Medicare Surtax on Capital Gains Income
There may be additional taxes on investment income or lost tax deductions for people with higher incomes. For example, married taxpayers with incomes of more than $250,000 will also be required to pay an additional 3.8% net-investment surtax. (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 2023
For those of you with short-term capital gains, these will normally 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
Gains in your 401(k), traditional IRA, Defined-Benefit Pension Plan, 403(b), and tax-sheltered annuities (TSA) will be tax-deferred. You won’t owe any taxes on the gains in your retirement accounts until 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.
2023 brings new contribution limits to these retirement plans, so consider increasing your contributions for 2023.
Taxation of Capital Gains on Real Estate
There are some 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.
Homeowners who are single (not married) 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 need to 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 may not be the same as your original purchase price. So, keep track of all those home improvements or remodeling projects you have spent money on 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 $6 million, then spend $1.5 million remodeling it, you will have a cost basis of $7.5 million. If you are married and have lived there for two of the past five years, you could sell it for $8 million without having to pay any capital gains taxes on the sale.
The 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 2023?
Taxes should only be part of the equation when deciding whether to buy or sell investments. This 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 financial planner and CPA to ensure you invest in the most tax-efficient manner and avoid paying unnecessary taxes.