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Most traders and investors just focus on learning how to make money from the market. Only a few focus on how to save the money they have already made from the market. Both are equally important.
Today, we are focusing on how to save the money you make from the market by not paying a hefty sum of it in taxes. So if you’re an active trader or investor, then this becomes important for you to learn how to minimize taxes on stocks.
Now, unless you’re a day trader, your ordinary income tax and taxes on stocks are not the same things. Thus, they require a different strategy depending on your income and time-frame.
To help us with this blog and you with taxes, we’ve got Preston Anderson from Anderson.tax with us. Preston is a Certified Public Accountant (CPA) and provides custom tax deduction solutions to individuals and businesses. In case you’re interested in his services, you can contact him on his website.
How Do You Pay Taxes on Stocks
Taxes on stocks are called capital gain taxes in official terms. You pay capital gain tax when you realize your gains by selling a stock or any asset for that matter. Until then, it is considered unrealized gains that are not taxed.
Basically, there are two types of capital gain taxes. The long-term capital gain tax that you pay on assets held for more than a year. And the short-term capital gain tax that you pay on assets held for less than a year.
The taxation system benefits the long-term investors more, thus long-term gains are always taxed at a lower rate as compared to short-term. The current tax rates for long-term gains are 0%, 15%, and 20%, depending on your total income for that particular year.
Short-term capital gains are taxed at your ordinary tax rates, meaning the tax bracket you fall in. Day trading income is also a part of short-term capital gains unless you qualify as a professional day trader in the eyes of the IRS. More on that in later parts of the blog.
Ways to Minimize Taxes on Stocks
So now that you understand how taxes on stocks work, it’s time to get to the nitty-gritty and the reason why you’re here, how to minimize your capital gain taxes.
Hold Long Term
As we just discussed, the taxation system favors the long-term investor. So the easiest and most straightforward way to minimize taxes on stocks is investing for the long-term.
You not only get preferred tax rates, meaning if you fall in the 24% tax bracket, your long-term gains are taxed at 15%, but if you fall in the 12% or lower tax brackets, then long-term capital gain tax for you is zero.
So if you fall in the 12% or lower tax bracket and have some large unrealized gains in your portfolio that you wanna realize. Rather than selling it all at once and bumping up your income for the year, what you can do is spread that over a couple of years and take advantage of the zero percent tax rate that you’re getting.
And as general advice, if you’re not doing stock market for a living, then you should ideally be invested in the markets for the long-term rather than realizing gains every now and then. It helps you maximize your profits and minimize your taxes.
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Time Your Gains to Keep Income in Check
By now, you understand that time plays a huge role when it comes to capital gain taxes, but now you’ll learn that timing is yet another factor that is equally important.
Because our country has a progressive tax rate system, where your income determines how much tax you owe in a particular year, it is important that you keep your income in check by avoiding big spikes and sudden downfalls in some years. You can do so by timing your gains.
If you have a large asset that you wanna get rid of, never sell it all at once because It’ll create an unnecessary spike in your taxable income, causing you to pay more in taxes for that year.
So for example, if you make $100000 in a year, your tax rate might be 12%, but if you make $200000, that tax rate becomes 24%. What you wanna do is utilize that 12% bracket as much as possible by avoiding unnecessary spikes in net income.
There are two strategies you can use to realize huge gains without bumping up your income. The first one, as we discussed above, is to spread your profit-taking over a couple of years or more.
Or what you can do is hold on to your asset till you retire and your income drops. Once that happens, you can realize huge gains without creating a spike in your net income.
If you’re a giving person, then that can help you save a lot in taxes.
If you’re a giver and donate to a charity by giving them cash. What you can do instead of selling your stocks to generate that cash is directly donate that stock to the charity without liquidating it.
That way, you don’t pay any tax on the capital gains because you haven’t realized it yet, and the charity also gets their donation, which they can liquidate anytime.
Now obviously, when the charity decides to realize those gains, they will be subject to capital gain taxes, which they’ll have to pay according to their legal structure.
Use Capital Losses to Offset Gains
Stock markets are not a one-way street where there will be only gains. You’ll obviously suffer losses too, which is not a bad thing if you look at it from a tax perspective.
You can use capital losses of any size to offset your capital gains and reduce your net income. This is called your net capital gains, which will be taxed.
In case your capital losses exceed your capital gains, that is called net capital losses, which you can deduct from your total taxable income. Though you can only deduct upto $3000 of net capital losses against your ordinary income in one year, you can carry over the remaining balance and keep deducting it for indefinite years.
You can also use it as a strategy to get rid of some or all of your losing investments at the end of a year to reduce your net income or avoid spikes in income to stay in those lower tax brackets.
For Short Term or Day Traders With Large Accounts
All that we focused on till now was how to minimize taxes on your long-term investments. But for short term investors and day traders, Preston has a very special method that can help you drastically reduce your capital gain taxes.
Now, this only works for people with huge gains like multiple hundreds of thousands a year, and large trading volumes, to qualify as a day trader in the eyes of the IRS.
There are other factors to qualify as well, but once you do that, all your short term gains become taxable whether you sell them or not, but the benefit is that you get to write off a lot of things because instead of capital gain income, it becomes your earned income.
So the strategy here is to take your trading gains and put them into a C Corp in a non-qualified plan. You continue to do all your trading inside that non-qualified plan, and instead of being taxed at 37%, you get taxed at just 21%.
Preston set it up for his clients in a very special and unique way that they don’t own the C corp. The benefit of doing so is, when they pull the money out of their non-qualified plan, there are no problems of double taxation.
Because when they pull the money out, that is a deduction to the company and an income to the trader, thus there are no problems of double taxation.
That wraps it up from our side. Now, you can go ahead and ask your accountant about which method will work best for you and if there are some other loopholes he recommends that you can use to minimize your taxes on stocks.