It’s always nice to sell something for more than you paid for it. However, that sometimes means that you have “capital gains.” And that means that you have to pay capital gains taxes. What is the best way to pay those to maximize your profit?
What Are Capital Gains?
You purchase an asset. Later, you sell it for a profit. That’s all that capital gains are. Typically, they refer to the profit that you make when selling property, land, a business, and luxury items including art, antiques, and boats. You also can have capita gains from the sale of stocks, bonds, and other investments.
Short-Term vs. Long-Term Capital Gains
If you buy and sell the asset within one year, it’s typically considered short-term capital gains. Those are taxed at regular income tax rates.
On the other hand, if you wait over a year from the time of purchase to sell the asset, it’s typically considered a form of long-term capital gains. Long-term capital gains are taxed at lower rates than short-term capital gains. Therefore, if you want to maximize your profit by reducing your taxes, then often you’ll want to wait until after that one year mark to make a sale.
Tip: If you are planning to sell your personal real estate, make sure that you’re aware of the exemptions for capital gains taxes on a primary residence. If you live in the house as your primary residence for long enough then you can avoid capital gains tax at the time of the sale. Therefore, timing is everything!
Net Capital Gains
You can have capital losses as well as capital gains. For example, let’s say that you sell a stock for $1000 less than you paid for it. That’s a capital loss of $1000. Now let’s say that in the same year, you sell a stock for a capital gain of $1000. You essentially break even. In terms of taxes on your capital gains, you can use the capital loss to offset the capital gain. So, you get taxed on your net capital gains, not on each capital gain. Note that net capital gains apply only to investments, not to other types of purchases.
Therefore, you might want to consider multiple big ticket investment sales in the same year. Do you know you want to sell something that you have to take a loss on? If so, it’s great to do that in the same year as a big capital gains sale. The loss will offset the gains and reduce what you owe in taxes.
There is a maximum that you can deduct each year in net capital losses. However, you’re allowed to carryover the extra into the following year as a new deduction. Make sure that you’re aware of these types of options.
Likewise, if you realize midway through the year that you’ve accrued a lot of income in capital gains, then you might want to assess potential investment sales for the rest of the year. If they’ll be a loss, then you want to sell before the end of the year in order to offset your capital gains. On the other hand, if they’ll turn a profit, you might want to hold off until the following tax year. It’s important to pay attention to the timing of your asset sales for this reason.
Your Income Affects Your Capital Gains Tax Rate
Finally, you’ll want to take your overall income into consideration. Capital gains are taxed differently depending on your income. For 2020-21, the capital gains tax rates are for single filers are:
- 0% for income at or below $40,000
- 15% for income $40,001 to $441,450
- 20% for income at or exceeding $441,451
Therefore, if you’re right around the $40,000 income mark (or the $441,450 mark), then you might want to review sales and income carefully before proceeding with a sale in any given year. This strategy is called harvesting your long-term capital gains. Rates differ for married couples, heads of household, etc. For example, the 0% rate is doubled to $80,000 for married couples filing jointly.
What Is The Best Way to Pay Capital Gains Taxes?
Timing your sales with respect to how long you’ve had the asset, what your income is for the year, and our overall net capital gains will all assist you in reducing the amount that you have to pay in capital gains taxes. Be smart ahead of time and you won’t have to pay as much at tax time.
Ultimately, however, if you have short-term capital gains, you have to pay taxes on them. If you have long-term capital gains are earn an income higher than the 0% rate shown above, then you have to pay taxes on them. Therefore, you’ll want to learn about the best way to pay those taxes.
IRS Forms and Tips
The IRS offers the following forms and information to assist you in calculating and paying your capital gains tax each year:
- Use Form 8948 to report your sales. This form will assist you in calculating your net capital gains for losses.
- Schedule D on Form 1040 is used to summarize your capital gains and losses.
- There is an additional Net Investment Income Tax for people who make a significant amount of money on investments. If this sounds like it applies to you, then make sure that you review those rules.
- If you owe taxes on capital gains, then you might need to make estimated tax payments. Therefore, if you buy and sell stocks and other assets regularly, then pay attention to this. Failure to make those estimated tax payments could result in paying more over the long haul.
If you don’t pay estimate taxes then you’ll need to pay your capital gains tax at the time that you do your taxes each year. If you paid attention to the timing of sales during the year, then you should be able to limit what you owe. However, if you do end up owing taxes, it’s best to pay them right away. If you are unable to do so, then you can apply for installation payments to the IRS. However, you end up paying more over time if you do so. Therefore, any time that you make a big sale, you should put some of that money away in savings in anticipation of paying taxes on it the following April.
Bonus Tip: Maximize Your Retirement Contributions
Make sure that you’re putting as much money as allowed into an Roth IRA or Roth 401(k). These are tax-exempt accounts. So even though you earn interest on the money that you put in there, you don’t have to pay capital gains tax when you withdraw the money.
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