A wonderful feeling might overtake you when you contemplate your stock holdings that show a profit. However, your elation might be punctured when you consider the stock market taxes you’ll pay on your profits. Before melancholy sets in, consider the available strategies for avoiding capital gains tax on shares.
Realized and Unrealized Gains
Your stocks may show a profit on paper, known as unrealized gain. Taxes are due only on realized gains, that is, profit on the sale of shares. When you postpone the sale of shares, you delay the taxes on stock gains. However, if you hold shares too long, their price might fall and wipe out your unrealized gain. Or perhaps you simply want to sell shares to redeploy your money elsewhere. Whatever the reason, you’ll keep more of your profits if you can reduce or eliminate taxes. The first step is to calculate your potential tax liability.
Cost Basis of Shares
The cost basis for a stock is the price you pay for the shares. Each purchase of shares is known as a tax lot, and you can own multiple tax lots of the same stock. You immediately adjust the tax lot cost basis to account for commissions and transfer taxes. When you sell the shares, your gain or loss is the sale proceeds minus the adjusted cost basis for each tax lot you sell. The sale proceeds are what you receive after subtracting commission costs and any other fees. Several kinds of events can occur that require further adjustments to your cost basis and that affect your taxable gains. Your broker reports your capital gains and losses from stock sales on IRS Form 1099-B.
Selecting Tax Lots
If your position in a stock consists of multiple tax lots, you can reduce your taxable gain by selling the shares with the highest cost basis first. For example, if you own 1,000 shares of stock purchased in four tax lots and you wish to sell 300 shares, you can instruct your broker which tax lots to sell. Choosing the highest-cost tax lots minimizes your taxable gain. When you receive Form 1099-B from your broker, the stock gains and losses will reflect your choice of tax lots.
Capital Gains Taxes
The profit from the sale of stock shares is taxed at capital gains rates. For shares held for less than a year, the short-term capital gains tax is equal to your marginal tax on ordinary income. As of 2018, there are seven tax rates on ordinary income ranging from 10 percent to 37 percent. However, shares held for a year or longer are taxed at the long-term capital gains rates of 0, 15 or 20 percent, depending on your income.
Treatment of Capital Losses
Capital losses can be used to offset capital gains. This provides another method to avoid taxation on your stock profits. If you can sell some stocks for losses in the same year you harvest a profit from winning stocks, you can reduce or eliminate your tax bill on your gains. You offset long-term losses against long-term gains first, and then against short-term gains. Short-term losses follow the same pattern of offsetting like gains first. Remaining losses can offset up to $3,000 of ordinary income, and any additional excess losses can be carried forward to offset future gains.
Using Tax-Sheltered Accounts
You can defer or eliminate taxes on stock market gains by trading stocks in a tax-sheltered account such as qualified retirement plan or IRA. The traditional versions of these accounts provide tax deductions for the money you contribute and allow you to earn profits sheltered from current taxes. You pay taxes, at your marginal tax rate, only on the money you withdraw, and you don’t have to start withdrawing money until you reach age 70 1/2. If you use the Roth version of a tax-sheltered account, you forego the tax deduction on contributions, but withdrawals are tax-free, as long as you observe the rules. With a Roth account, you completely avoid taxation on your stock market profits, as long you don’t withdraw earnings before age 59 1/2 or within the first five years after your initial contribution.
Contributing to Charity
Another way to avoid the tax on stock market profits is to donate your shares to charity. If you hold the shares for at least a year, you can donate them at their current value, and take a tax deduction in that amount if you itemize. Short-term holdings are donated at their cost basis, so it pays to wait until you’ve held the shares for a year. In some cases, your stock donations might help you reduce your overall tax burden by keeping you out of the next-highest tax bracket.
Tax-Free Stock Transactions
Some stock transactions are not taxable events. These include:
- Replacement of old shares with new ones after a merger or acquisition
- The spinoff of a corporate division to shareholders as a separate company
- Stock splits and stock dividends, including reverse splits
- Conversion of preferred stock into common stock
- Replacement of one class of common stock with another
Some of these transactions might affect the cost basis of your shares. For example, a two-for-one stock split halves the cost basis (and price) of each share. This will automatically be reflected on the 1099-B you receive if and when you sell the shares.
Taxes on Mutual Fund Shares
Many investors choose to own stocks through a mutual fund. Instead of selecting the stocks to own, you purchase a portfolio of stocks chosen by the fund manager. This is a classic way to achieve instant diversification of your holdings, thereby reducing your overall risk due to a loss on a particular stock. While mutual funds offer investors several advantages, they do make it harder to avoid capital gains tax. The reason is that each year, a mutual fund must distribute all of its realized capital gains to shareholders.
You receive capital gain distributions (which are classified as long-term) even if you haven’t sold your mutual fund shares, which would create a separate short- or long-term capital gain or loss. Automatically reinvesting the capital gain distribution in additional mutual fund shares does not diminish your tax liability. Nor does exchanging shares of one mutual fund for another.
However, the other methods of reducing taxes on stock gains can be used with mutual fund shares, including the use of tax-sheltered accounts and tax lot selling of losing positions. You can also choose to sell your mutual fund shares just before the capital gains distribution date. While this will allow you to sidestep the taxes on the distribution, it will generate a capital gain on the sale of any shares for more than their adjusted cost bases.
Taxes on Dividends
In addition to the capital gains you might experience when you sell stock shares, you might also receive taxable income in the form of stock dividends. Dividends from most U.S. stocks and some foreign ones qualify for taxation at the long-term capital gains rate, even if you held the shares for less than a year. You must have held the shares for more than 60 days within the 121-day window centered on the stock’s ex-dividend date to qualify for the long-term capital gains treatment. If you prefer to avoid dividends and their associated taxes, you can select stocks that don’t pay dividends or use a tax-sheltered account. Some mutual funds are managed to minimize dividends.
- There are no guarantees in the stock market. Past performance is never a guarantee of future results.