Benjamin Franklin is credited with saying, “In this world nothing can be said to be certain, except death and taxes”. More than 220 years later that assertion still holds up, sort of. Though we’re living longer, we still haven’t found a way to throw the reaper off of our trail. However, there are a number of acceptable methods to lessen the burden of taxation on your investment income. One way to do this is to understand the rules around capital gains taxes.
If you’ve played the investment game for any amount of time, you should be aware by now that short-term capital gains are taxed at a higher rate than long-term capital gains. Short-term capital gains are the profits accumulated from selling any investment held for less than a year. As with all other taxes, the percentage you owe hinges on your annual income. Short-term capital gains are taxed at the same rate as ordinary income, but long-term capital gains incur a significantly lower rate. Depending on your tax bracket, your long-term capital gains tax can be 10, 15, or 20 percent lower than your income tax rate.
As a result, most investors believe it’s wise to just hold on to their investments for at least a year before selling them off, especially when using a non-qualified account. But if, for some reason, you feel compelled to hold them for less than a year, you can conduct short-term trades in your IRA which will allow your gains to grow tax deferred and withdrawals from the account will be taxed as ordinary income. You get bonus points if you’re using a ROTH account as there is no tax liability for the gain.
Now, this strategy can be tricky which is why we always recommend working closely with a financial professional to ensure you don’t run afoul of any regulatory requirements governing brokerage accounts like IRAs. Additionally, you need to analyze your annual income on a regular basis so that even your long-term capital gains aren’t taxed at a higher rate than necessary due to being bumped up to a higher tax bracket.
So for the most part, Ben was right. Death is certain and, yes, so are taxes. But what’s not certain is how much tax you’ll actually have to pay. Knowing the rules and adjusting your approach can save you a lot of money. Most importantly, you need to have a comprehensive tax strategy if you want to keep as much money as possible in your pocket.