Building long-term wealth is about more than working hard every day. It’s also about making well-informed financial decisions. These decisions are what will end up making your financial goals a reality. After seeking professional guidance, the best thing you can do for yourself and your bank account is to become educated. Most of us know that there are more ways to make money than by working. You may have even heard the phrase, “It takes money to make money.” It’s true that strategic investment decisions and a well-rounded portfolio can be instrumental in creating lasting wealth for you and your family — capital gains play a central role in the financial lives of high-net-worth investors.
In fact, the wealthiest people in the USA make up to 44% of their income from these.
What are Capital Gains?
Capital assets are not unique to the super wealthy; we’ve all got them. A capital asset is any piece of property that’s worth something. It could be your car, collectibles, real estate, stocks, or bonds. And for many, their most valuable capital asset is their own home.
For businesses, capital assets are those that the business intends to use for more than one year and that help the business turn a profit in one way or another. For individuals, capital assets are any piece of significant property that they own.
They are the financial gains that result from selling a capital asset. This happens when the value of an asset rises higher than the purchase price and then the asset is sold for a profit.
It’s most common to associate capital gains with the stock market. Investors make money by selling stocks and bonds for more than their purchase price. And these gains are a taxable event. It’s not just investors who experience capital gains, however.
The sale of any property for more than its purchase price is subject to a specific tax, and this applies to everyone.
What About the Tax on These?
The capital gains tax is something that affects most people at one point or another, and it’s important to understand how it works.
The sale of an asset for more than its purchase price is what triggers this tax. An asset that has risen in value but hasn’t been sold does not count as a taxable event. These are called unrealized gains.
Capital gains are classified as long-term or short-term, and the distinction impacts how much tax you’ll owe on them.
These are the capital gains made from the sale of an asset that you have held for more than one year. The taxes for these gains depend on your tax bracket and will be 0%, 15%, or 20%.
These capital gains come from the sale of assets held for less than a year. They’re subject to the ordinary income tax rate, which will depend on your tax bracket. This means that the short-term capital gains tax is higher than the long-term rate.
Net Capital Gains
Of course, assets can also be sold for less than their purchase price. When this happens, it’s called a capital loss, and this is also relevant in calculating how much capital gains tax you would owe. You can arrive at your net capital gains by deducting your capital losses from your gains.
If your losses exceed your gains, resulting in negative net capital gains, you can deduct this difference from your tax return.
Special Capital Gains Tax Rates
Aside from the rates above, some assets are subject to their own capital gains tax rate. It’s worth noting that these rates do not apply to businesses that sell a certain type of asset. In the case of the gold coin dealer, sales on gold coin investments are treated as the business’s regular taxable income as opposed to capital gains.
The following special capital gains tax rates apply to individuals.
Collectible assets include things like precious metals, art, stamps, jewelry, baseball cards, etc. Any gains on these assets are subject to a fixed tax rate of 28%.
Depending on your tax bracket, this can be good news or bad news. If you’re in a tax bracket lower than 28%, you’ll still have to pay the higher rate. If you’re in a higher tax bracket, however, you still won’t be taxed any more than 28%.
The rules for capital gains tax on real estate depend on whether you’re selling an investment property or the house you live in. If you’ve lived in the property for at least two years and it is your primary residence, you won’t have to pay tax on the first $250,000 from capital gains. This number jumps to $500,000 for those married filing jointly.
This is a great tax break to take advantage of when selling your home. On the other hand, it’s important to note that capital losses from the sale of real estate are not deductible from your net gains.
The Net Investment Income Tax
Some investors will be subject to an additional tax if their investment income meets the required threshold. The net investment income tax is 3.8% and must be paid on investment income if your adjusted gross income exceeds the following amounts:
Single or Head of Household: $200,000
Married filing jointly: $250,000
Married filing separately: $125,000
How to Pay Less Capital Gains Tax
Minimizing taxes is the name of the game when it comes to building and maintaining wealth, and it’s all about how much you know. While hiring a tax specialist is often the best move for navigating complicated tax law, there are some basic moves you should be aware of when it comes to paying capital gains tax.
Tax-Advantaged Retirement Accounts
This is one of the best ways to mitigate taxes on your investments. Retirement accounts like a 401k and IRA have significant tax benefits that can help reduce the amount you’ll pay for your capital gains.
Contributions to these accounts are tax-deductible and can put you in a lower tax bracket. You will, however, need to pay regular income tax on the distributions you collect after retirement.
A Roth IRA, on the other hand, has the advantage of letting your investments grow tax-free. In exchange for paying taxes on the contributions you make to your Roth account, you won’t have to pay any tax on the withdrawals you make from the account in retirement. This is a great way to exempt yourself from paying capital gains tax and is especially useful for people who believe they will be in a higher tax bracket when making withdrawals from the account.
Capital Loss Rollover
This is an important one to be aware of. If your net capital losses are more than you can deduct from this year’s federal tax return, you can carry over the difference and deduct it from next year’s tax return.
Longer is Better
Be sure to stay aware of the difference between your long-term and short-term assets. The long-term capital gains tax rate is significantly lower than the short-term rate. When possible, hold on to your assets for at least a year before making a profit on them. This is often a simple way to decrease the amount of tax you’ll owe.
Coordinating Gains with Taxable Income
Remember that the amount of capital gains tax you pay will depend on your tax bracket. If you made more money this year and are already expecting to pay higher income taxes, it may be worth it to wait until a lower-income year to make capital gains.
On this note, you may also want to consider timing the sale of an asset with retirement. If you expect your retirement income to be lower than your working income, it may be beneficial to wait until you’re finished working to sell your assets.
For most of us, paying capital gains tax will be a part of life at one point or another. This shouldn’t be a demotivating factor when it comes to investing in capital assets that will later net you a capital gain. By managing your investments wisely and timing the sale of your assets in an intelligent manner, you will be able to pay much less than someone that puts little thought into their financial decisions.
Capital gains are an amazing way to make money. Those who have done their homework are rewarded with bigger profits and are much more likely to meet their financial goals. If you want to be absolutely sure that your wealth is managed properly, you don’t have to go it alone.
At Saddock Wealth, we bring years of wealth management experience to the table and can guide you toward financial prosperity. Make sure your wealth is in the right hands and ready to grow in 2020.