Some of President Biden's proposed tax law changes have caused quite a ruckus, especially those surrounding changes to capital gains tax and cost basis provisions. What this means for you is that, in nearly all cases, there are some general practices that can keep your tax bill low. Below you'll find three ways to ensure you keep as much of your investment gains as you possibly can.
1. Hold investments for longer than a year
Tax laws favor long-term investing; you'll pay a far lower rate of tax if you hold your stocks and bonds for longer than a year. If you're a day trader, you'll need to get used to paying ordinary income tax on any locked-in gains, but if you're a long-term investor, you'll be eligible for favorable long-term capital gains rates after you've held an investment for more than a year.
Now on to the why. Short-term investing is usually associated with speculation as opposed to true investing. If you're trying to make money on volatile spikes of a stock or cryptocurrency, you're not really investing -- you're speculating. The law encourages you to buy and hold investments that have a reasonable probability of increasing in value over the long run. You'll be in much better "tax shape" if you stick to a buy-and-hold philosophy.
One important exception to this is if you're earning over $1 million annually. One of President Biden's tax proposals is to eliminate the preferential long-term capital gains tax for these taxpayers. While this is a small fraction of taxpayers, and there is no telling exactly how this will play out, holding investments longer than a year wouldn't offer the same advantage in this specific case.
2. Own real estate
If you own real estate, you're eligible to exclude $250,000 worth of gains on your property at the time you sell (if you're a single filer). The number rises to $500,000 if you're married and file a joint return. Any gains above these exclusions would be taxed at capital gains rates, assuming the property is your primary residence and you've lived in it for two of the last five years.
This means that if you're a married taxpayer and you were to buy a home for $500,000 and sell it in the future for $1,000,000, your entire gain would be excluded from tax. This is a huge opportunity -- as well as a low-hanging fruit -- for people with sizable assets or those simply wanting to avoid capital gains tax.
Separately, if you own real estate, there's a good likelihood you also have a mortgage. When it comes time to file your tax return, homeowners are eligible to deduct mortgage interest on loans of up to $750,000. While not a reason to own in and of itself, using interest payments to your advantage is an additional plus.
3. Max out retirement accounts
Money held in taxable accounts is taxed continuously and when gains are realized. If you buy a stock that generates quarterly dividends and increases in value, you'll be taxed twice: when you receive dividends and when you sell the stock. Changes to tax law could raise both the investment income and capital gains rates associated with taxable accounts.
Enter your retirement accounts, particularly the Roth IRA. You'll contribute after-tax money, but you won't pay tax on investment income or capital gains tax on growth -- even when you withdraw the money in retirement. Roth IRA contributions are capped at $6,000 per individual for 2021, and direct contributions are limited by your income. Still, the Roth IRA stands as one of the most powerful retirement accounts in today's tax landscape.
Tax-deferred retirement accounts -- like 401(k)s and 403(b)s -- present additional planning opportunities. Unlike the Roth IRA, you'll receive a tax deduction today to contribute to a tax-deferred retirement plan and you'll pay ordinary income tax upon withdrawing the money. But you won't be subject to any investment income or capital gains tax along the way. Your employer-sponsored retirement plan is another way to shelter investment money from continuous taxation, so make sure to contribute as much as you can.
A balanced approach
Without guessing too much about what the future may or may not hold, it's a reasonable assumption that tax rates (both on regular income and capital gains) will rise in the future. Knowing this, it pays to think about the ways you can shelter, defer, and legally avoid these taxes before they become an immediate reality. Take care to create a financial plan that reflects your expectations and be sure to consider a range of possible outcomes.