You know that old story – “Warren Buffett pays a lower tax rate than his secretary!” Is it true? Let’s take a look.
He might – if he is paying taxes via long-term capital gains and his secretary is making a rather large salary (taxed at normal income tax rates). The key here is that long-term capital gains are taxed at a more favorable set of rates versus ordinary wage income.
For investments within taxable brokerage accounts (NOT a 401(k) or IRA!), the first thing to know is that stocks held for more than 12 months, then sold at a gain, are taxed quite favorably in the United States. The current law dictates that the ‘long-term capital gains’ tax rate is topped out at 23.8%, but it is 15% for most individuals. In fact, if your income is low enough, gains sold after a year may have no tax liability at all! As a reminder, the only portion taxed is your gain (not the entire sale).
Uncle Sam will ding you a little more if you buy and sell a stock within 12 months – assuming you have a gain. Then whatever your gain on the sale is will simply be taxed at your normal income tax rate.
Moving on from capital gains taxes, what about dividends? Once again, there is a little twist we have to deal with on this topic. There are Qualified dividends, which means the stock or fund that paid the dividend was held for at least 61 of the past 121-day period that began 60 days before the stock or fund traded without the dividend. That was a mouthful! But you can’t argue with the IRS. Qualified dividends are taxed at the relatively favorable long-term capital gains rate.
Non-qualified dividends – say you bought the stock last week and sold it this week, while capturing the dividend payment, then you will be liable for the dividend to be taxed at your ordinary-income tax rate. So basically, the IRS is encouraging folks to hold onto investments for longer periods of time as opposed to speculating on the near-term.
How about mutual funds & exchange-traded funds (ETFs)? These are very similar to the long-term and short-term capital gains rules of stocks and bonds. Funds held more than a year, sold with a gain, are taxed at favorable long-term capital gains rates while gains derived from holdings of 12 months or shorter are taxed at the higher short-term capital gains rates (which is your marginal income tax rate).
Here’s a bone the IRS tosses that we can take advantage of – capital losses. Nobody likes to lose money, but what we can do is sell a position that has gone down a little bit to reduce our income. If you buy a stock worth $10,000, then sell it at $7,000, you have a $3,000 loss. You can deduct that $3,000 from your income to save on taxes. Meanwhile, you can buy a similar stock or fund to stay in the market (so it’s not like you are locking in a loss). And you are allowed to ‘carry-forward’ those capital losses to future years since the IRS only lets you take $3,000 of losses each year.
What’s cool is not paying taxes. At least that is cool in our minds! There are legal ways you can go about avoiding taxation. Remember: tax avoidance is a great strategy while tax evasion is illegal!
Here are a few ways you can avoid taxes on your investments.
- Use your 401(k): By contributing to your 401(k) (pre-tax) today, you reduce your current year’s taxable income. If you are in the 24% tax bracket, and you put in $1,000, then you save $240 when you go to file next year. Of course, you will pay taxes on withdrawals in retirement (which may or may not feature a lower tax rate). You could hypothetically avoid taxes altogether on your contributions by converting to a Roth account during a year when you have little to no income.
- Contribute to your Health Savings Account: Your HSA is the only account where you can easily avoid taxes – you get a current-year tax deduction for contributions, then avoid taxes on dividends and capital gains as the account grows, and withdrawals for health reasons are not taxed. It’s a triple-tax-advantage!
- Donate highly appreciated stocks: the IRS also encourages you to give to charity. When you gift stock to a charity, you avoid capital gains liability (and you might be able to deduct the gifted amount from your income when you file your taxes). By the way, the charity receiving the stock won’t pay taxes either (assuming they meet the IRS guidelines as a non-profit charity).
Here’s the point
- Paying more tax is not the most fun thing in the world, but it usually means you had extra income, so happy about that.
- In general, holding a stock or bond for 12 months or more results in lower tax rates when you go to sell it (assuming you have a gain).
- Use legal tax avoidance methods to reduce taxes during your peak earnings years – then target years in which you may have a lower income to perform conversions to Roth accounts (we can help you strategize this).
Action items
- Beef up your 401(k) and Health Savings Account contributions to reduce your taxes. If you are in a low tax bracket or are in a low earnings year, then a Roth account (a Roth IRA or Roth 401(k)) could make more sense.
- Don’t fret about paying tax on capital gains and dividends – don’t let “the tax tail wag the investment dog”! Many folks get hung-up on a few extra dollars of tax liability, then lose sight of the long-term goal of their financial plan.
- You can consider giving to your favorite charity, including most churches, stocks, and mutual funds instead of cash to save on taxes.
Image by Steve Buissinne from Pixabay