Capital Gains Taxes 101: 10 things to know
A quick primer on how your taxes are calculated and how to best optimize them.
As tax season is rolling around the corner and tax loss harvesting season is quickly approaching, we wanted to share ten things to keep in mind!
It’s easy to forget about taxes or avoid thinking about them, but to be in the top tier of investors, you should always pay close attention. Taxes not only cut out a significant portion of your total return, but they can also become quite burdensome on your budget if you owe a large sum to the IRS.
With that said, here are our top ten things to know about your taxes:
The IRS expects you to pay taxes as you earn income. Therefore, you can’t just think about it once a year during tax season. For investors especially, you should keep quarterly tax deadlines in mind if you’ve incurred substantial gains as you may have to pay an estimated quarterly tax or risk an underpayment penalty.
You often have to pay state capital gains tax on top of your federal tax. Some states like California levy up to an additional 13.3% tax but others like Alaska have no tax.
Your base tax rate is at the intersection of your filing status (e.g. single, married filing jointly, married filing separately, head of household) and your ordinary income (i.e. money earned from working so wages, commissions, tips, etc.). Find out what your tax rates are here.
Short-term capital gains occur when you’ve held onto the investment for a year or less. Anything held for longer is considered a long-term gain. Short-term gains are taxed the same as your ordinary income, which has higher tax rates. So one should always look to minimize short-term gains and optimize long-term gains.
Capital gains are taxed on a progressive scale so every dollar is not subject to the same rate. So while your base tax rate could be 22%, if you have a large sum of capital gains, some of that may get taxed at 24%, 32%, etc. Here’s why the progressive rate provides more tax savings than a flat rate system.
If your income is above a certain threshold, you are subject to an additional 3.8% net investment tax. Those thresholds are $200,000, $250,000, $125,000, $200,000 for single, married filing jointly, married filing separately, head of household respectively.
Wash sales are a lesser-known rule that can disrupt an investors tax liability. Wash sales disallow losses if investors rebuy the same company’s stock or options within 30 days of incurring a loss. Essentially, the IRS prevents investors from booking a loss if they still intend to hold shares in the company.
Tax loss harvesting is one of the most critical skills for investors to master. It helps investors limit their tax liability and boosts long-term returns.
You can offset losses across your investments. So, for example, you can offset losses from your collectibles, like NFTs, against your gains from stock appreciation. Keep in mind that all the gains and losses (if applicable) in each character category are netted first within each category. So in layman’s terms, you have to first net your gains and losses within NFTs before they can be deducted from your net stock gain.
When deciding how to calculate your gains and losses, you have multiple options. The most common are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), Average Cost Choosing, or Specific Identification. The former is most often used as the industry standard even though it’s the worst! For Robinhood users, unfortunately, all of your sales are processed using the FIFO method. Often, specific identification is the best strategy as it provides the most flexibility to sell your short-term losses.
There’s your top 10! If you want to learn more about taxes, feel free to reach out to me directly here or continue to follow us on Twitter.
Disclaimer: The above content is provided for general informational purposes only. It is not intended to constitute investment advice or any other kind of professional advice and should not be relied upon as such. Before taking action based on any such information, we encourage you to consult with the appropriate professionals.