3 Easy Strategies to Avoid Capital Gains Tax

The end of the year is a time for reflection, and that also applies to your investment accounts. Many people choose to rebalance their portfolios as the year comes to a close, so it’s especially important to know the effect of your trading actions on your tax bill coming in April.

Below, you’ll find three easy-to-apply strategies to reduce or even eliminate any potential capital gains tax in 2021.

1. Tax-loss harvesting

If you have losses in your taxable brokerage account, you’ll be able to offset them against any gains to avoid capital gains tax. First, you’ll need to net gains and losses of the same type. For example, short-term gains can only be netted against short-term losses, and long-term gains can only be netted against long-term losses. From there, you’ll again net the total to come up with a final number that’s reported on your tax return.

This is likely best illustrated with a numerical example. Say you have $5,000 in short-term losses for the year (i.e., you bought a stock earlier this year and have seen it fall in value by $5,000). At the same time, you have another stock that you purchased earlier in the year that’s gone up in value by $2,000.

If you were to sell both stocks, you’d lock in a short-term loss of $5,000 and a short-term gain of $2,000, leaving you with a net short-term capital loss of $3,000. Fortunately, not only would you avoid paying any tax on the stock that generated a gain, you’d also be able to deduct the $3,000 short-term capital loss as a deduction against ordinary income on your tax return.

Image source: Getty Images.

2. Rebalance in retirement accounts

When you rebalance in your taxable brokerage account, you’ll pay tax on any realized gains. For example, if you bought a stock that went up in value and then you subsequently sold it, the IRS would come knocking. However, there’s a different story if you trade in your retirement accounts.

Because popular retirement vehicles [like Roth IRAs, 401(k)s, and 403(b)s] are tax-advantaged accounts, you’ll only owe tax when you contribute or on the way out when you finally take a distribution. This allows you to trade freely within your retirement accounts without fear of any capital gains tax — short or long term.

If you have a financial plan that calls for semi-annual rebalancing, it’s to your advantage to do your rebalancing in a retirement account where you know there’s no real downside to reallocating your money. Knowing this allows you to be more deliberate when bringing your pre-determined asset allocation back in line.

3. Don’t do anything

Leaving your investments alone — regardless of how they’ve performed — is a tried-and-true strategy for paying no capital gains tax. Even if your investments have appreciated generously this year (and it’s possible they have, given the S&P 500’s 20%+ gain in 2021), there’s no reason to change what’s been working for you unless you need the money now.

Alternatively, you can defer investment sales to 2022, which would push any potential capital gains tax due to 2023. This is an effective strategy if you already have a hefty tax bill coming up in April or don’t have any losses this year to offset gains. Here, you’d still owe tax but would have the benefit of a longer runway to finally pay it.

Learn the rules first

If you know the basic rules around capital gains tax, you can work to minimize it, even as your investments grow. As both your income and assets increase over time, the value of knowing the details will grow, as well. It’s about intentionality: If you’re very savvy with regard to every trade you make, you’ll be in a far better position when it comes to dealing with the IRS.

10 stocks we like better than Walmart
When our award-winning analyst team has an investing tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

They just revealed what they believe are the ten best stocks for investors to buy right now… and Walmart wasn’t one of them! That’s right — they think these 10 stocks are even better buys.

See the 10 stocks

Stock Advisor returns as of 6/15/21

The Motley Fool has a disclosure policy.

Leave a Reply

Your email address will not be published. Required fields are marked *

Related Posts