If you’ve ever bought and sold a rental property, a stock, or any investment, you were likely charged capital gains tax, whether you know it or not.
Capital gains tax gets a pretty bad rap, and rightfully so. This tax can take a huge cut of your profits from investments.
I’ll show you how it works, why it can be disadvantageous for investors, and how to avoid capital gains tax to a certain extent. That’s right, there are strategies you can follow that can greatly reduce the taxes you pay on your profits so you can keep more of your money.
When you invest the Rule #1 way, you can easily avoid capital gains tax. Here’s how.
What is Capital Gains Tax?
Capital gains tax is a federal tax that occurs when you profit from the sale of an investment (i.e. when you sell shares of a stock for more than you paid for it).
You get taxed on the amount you profit from the sale, or the capital gain.
Capital gain = selling price – purchase price
Stocks aren’t the only assets that are taxed under capital gains tax. Other capital assets include bonds, jewelry, vehicles, collectibles, and property, such as your home. Now, if you want to learn how to avoid capital gains tax on real estate, that’s a topic for another time. Here, we are going to focus specifically on stocks.
The capital gain falls into one of two categories that depend on how long you owned the asset or stock for— a short-term capital gain or a long-term capital gain. The distinction between these two is critical as the amount you will pay in taxes on each type varies greatly.
Short-Term Capital Gains
Short-term capital gains are gains on stocks that are held for one year or less. Short-term capital gains are taxed at your ordinary-income tax rate, which could be as high as 37% per 2020-2021 tax brackets, not including state income tax.
Profits from the sale of a stock that you held for, say, nine months and then sold, are taxed at this rate. We’ll get to it next, but this is much higher than long-term capital gains tax.
Long-Term Capital Gains
If you hold an investment for more than a year before selling, your profit is considered a long-term capital gain and is taxed at the capital gains tax rate, which is either 0%, 15%, or 20%. This is based on your taxable income and filing status (i.e. single, married, head of household, married filing separately).
These rates are pretty straightforward, but there are some additional rules. For instance, high earners will owe an additional 3.8% on capital gains.
For every level of income, the long-term capital gains tax rate is less than the short-term capital gains tax rate. This means if you hold your investments for longer than one year, you could pay far less in taxes on the profits gain.
Let’s put this into perspective. If you make around $90,000 a year and purchased a company in September of 2020 for $10,000 and sold it in August of 2021 for $15,000, you would pay at least $1,200 in capital gains taxes.
If, however, you held onto the company until now (longer than one year) and then sold it for the same price, you would pay about $750 in capital gains taxes.
That’s a difference of 37.5%!
This is why it’s so important to invest with a long-term mindset.
It’s right there in the numbers — our tax system is set up to benefit long-term investors!
The Rule #1 investing strategy is a long-term strategy that benefits investors in so many ways, like saving on taxes.
How to Avoid Capital Gains Tax on Stocks
So, long-term capital gains are better than short-term capital gains, and as a Ruler, you should only have to deal with these anyways. However, taxes are taxes, so there’s a downside to long-term capital gains taxes too. But if you follow these tips, you can make the most of your tax situation.
Buy & Hold for the Long-Term
As Rule #1 investors, we strive to invest in wonderful companies that will continue to grow for five, ten, or even fifteen years. The goal of this strategy is to see our money grow and compound and grow some more until we have created incredible wealth that will support us and help us survive.
That means watching investments double and triple in value over a matter of years. Not only will following this strategy make you money, but it will save you money on taxes too.
If you call yourself a Ruler, you will want to buy and hold your investments anyway, so avoiding short-term capital gains is relatively easy.
Remember this. Don’t be influenced by peer pressure to sell early or to take part in day-trading. These tactics are like the shiny poison apple; they look enticing but will only hurt you in the end.
Another way to avoid short-term capital gains is to set your investments and forget about them. Set price triggers to notify you if they drop in price so you can buy more and set news alerts to be notified of any major company news. Otherwise, leave your investments alone so you won’t be tempted to sell them before you should.
Apply Rule #1 Value Investing Strategy
Now, the above only applies if you have actually done the work and researched the companies you are investing in to ensure they are indeed wonderful.
You can feel confident in buying and holding your investments for the long-term when you know the value of the company. This means checking off all of the 4Ms before you hit buy.
Anytime you consider selling your ownership in the company, revisit the 4Ms to see if the stock price is still below the value, or if it is overvalued.
There are some instances where it will make sense to sell (even if you have to pay short-term capital gains tax). For one, if the stock price jumps above what you think the company’s intrinsic value is, it’s time to sell.
Second, if the company’s story changed for the worse— such as they hired a terrible new CEO or they were bought by a company you know nothing about— then it may also be time to sell.
Finally, if you need the money from an extremely profitable investment for a better investment where you can get better returns, you may also want to sell.
The rule in these cases is that you could easily lose more than you’d save on capital gains tax by holding onto the company a little longer. Apart from these three instances though, you never want to let a wonderful company go.
Your investment could continue to grow (even if it’s already doubled!) and you don’t want to make the mistake of selling a wonderful company for the wrong reason, or just because you got a little greedy.
Exploit Tax-Deferred Retirement Plans
The only sure way to avoid capital gains tax on your investments is to utilize a tax-free or tax-deferred retirement account. These include IRAs, Roth IRAs, 401ks, and 403bs. With all of these accounts, you can buy and sell stocks without being charged capital gains tax — ever.
With a tax-deferred account, such as an IRA, 401k, or 403b, you can contribute pre-tax dollars, but the gains will be taxed as ordinary income when you withdraw the money. However, when you retire, you may be in a lower tax bracket than you are in now, and thus will pay less in taxes.
Additionally, you can deduct your contributions from your income, thereby reducing your taxable income, and perhaps even putting yourself into a lower tax bracket.
With a tax-free account, such as a Roth IRA, you contribute after-tax dollars but can withdraw the money tax-free during retirement.
Of course, the main reason you may not be able to avoid capital gains tax all of the time by doing this is that there are contribution limits on these accounts. But, it’s smart to contribute as much as you can and invest that money the Rule #1 way because when you make a profit, you won’t be charged capital gains tax.
The Bottom Line
If you’re a ruler, you’re already investing in a way that will help you avoid a big portion of capital gains tax. Stick to that long-term mindset and you’ll save more money on taxes and avoid falling into the traps of day trading or purchasing stocks with a short shelf life.
If you want to learn more about how to reduce your risk, enhance your profit, and benefit more from your investment decisions, grab my Cheat Sheet for Smarter Investing.
Now… go play.
Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.