Kevin Canterbury of Arizona is the Managing Director and Founder of Redstone Capital Management, LLC, with a background in the U.S. Army's Military Police. After serving in Japan, Alaska, and Central America, he transitioned to the financial services industry in 2004, quickly earning his CLU and ChFC designations while working for a Fortune 500 firm. In 2010, Kevin launched his own firm, where he focuses on providing personalized financial planning and investment advice to a diverse clientele, emphasizing one-on-one meetings to tailor his services to each client's unique goals and needs. Below, Kevin Canterbury explains what capital gains taxes are, how they occur, and offers strategic tips to effectively manage and limit their impact on your investments.
Capital gains taxes are a significant revenue source for the federal government, and for us investors, they're a significant expense we must manage. The interplay between federal and state capital gains tax rates, as well as the net investment income tax, can greatly influence our investment decisions, such as when to sell an asset. But don't fret! There are ways to limit your exposure and offset your capital gains.
Kevin Canterbury Explains Capital Gains Taxes
Capital gains taxes are levied on the
profit made from selling assets such as stocks, bonds, real estate, and other investments. If the sale price exceeds the purchase price, the difference is considered a capital gain and is subject to taxation. These taxes are categorised into short-term or long-term gains, based on how long you've held the asset before selling. Short-term capital gains are taxed at a higher rate, reflecting the income tax bracket, while long-term gains benefit from lower tax rates.
How to Limit Exposure
Limiting your exposure to capital gains taxes involves several strategies that can help minimise the amount owed at the end of the fiscal year. These strategies focus on timing, choosing the right investment vehicles, and leveraging losses to offset gains.
Tips to Manage Exposure
Kevin Canterbury reports that each of these tactics can be used individually or in combination, depending on your individual circumstances and financial goals.
Match asset location and investment choice
Different types of investments are taxed differently, so it's beneficial to match the type of investment with the most appropriate account type. For instance, investments likely to incur high capital gains should be held in tax-advantaged accounts like Roth IRAs, where withdrawals are tax-free. Conversely, tax-efficient investments, such as municipal bonds, can be placed in taxable accounts.
Take a longer-term view
Capital gains taxes are lower for investments held for over a year, classified as long-term. Kevin Canterbury says that by holding investments longer, you not only reduce the tax rate on gains but also allow your investments more time to appreciate in value, benefiting from compounding returns over time.
Harvest tax losses
Tax-loss harvesting is a strategy to offset taxes on gains and income by selling securities at a loss. Use these losses to counterbalance capital gains, and if your losses exceed your gains, you can use up to $3,000 a year to reduce your ordinary taxable income.
Harvest tax gains
In years when your income is lower, intentionally realizing capital gains can be beneficial as it might place you in a lower tax bracket, reducing the amount of tax paid on long-term capital gains. This is particularly useful in retirement planning or career transitions.
Monitor mutual fund distributions
Monitoring mutual fund capital gains distributions is another key strategy for managing capital gains exposure. Mutual funds are required by law to distribute at least 98% of their net capital gains to shareholders annually, usually around November or December. This means that as a mutual fund investor, you must consider the tax implications of these distributions.
One effective tactic is to sell your mutual fund shares before the fund's distribution date to avoid a capital gains tax event. This strategy requires diligent monitoring of your mutual fund's distribution schedule and can help you avoid unexpected tax implications.
Give away appreciated assets
Kevin Canterbury explains that by donating appreciated stocks or real estate to a charity is not only philanthropic but also offers significant tax advantages. The current market value of the donations can typically be deducted, and you avoid paying capital gains tax on the appreciated portion of the asset.
Invest in distressed communities
Investing in qualified opportunity zones can offer tax incentives, such as deferrals and potential exclusion of taxable income for gains reinvested in these areas. This can significantly reduce your capital gains on other investments when managed correctly.
Consider securities-based lending
If you need liquidity but don't want to incur capital gains, consider securities-based lending, where you borrow against the value of your portfolio. This way, you retain your investment position and potential appreciation while avoiding capital gains taxes.
Diversification to Reduce Concentrated Capital Gains Risk
Diversifying your investment portfolio can be an effective way to manage and reduce the risk of concentrated capital gains, which may lead to substantial tax liabilities. This strategy involves spreading your investments across various assets to minimize risk.
Kevin Canterbury reports that there are several ways to achieve diversification, one of which is by investing in equity exchange funds, which let you pool a significantly appreciated stock with others, providing instant diversification without immediate capital gains taxes.
Hire an advisor
While it's possible to manage your capital gains exposure on your own, hiring a financial advisor can make the process much easier and more effective. Advisors can help you navigate complex investment scenarios and optimize your cost basis to minimize capital gains taxes.
Financial advisors can assist in creating personalized financial plans that aim to achieve your financial goals. Some of the areas they can help with include:
- Investments
- Savings
- Budgeting
- Insurance
- Tax planning
They can guide you through the process, educate you on various financial matters, and provide regular check-ins to re-evaluate your situation and adjust your financial plan accordingly.
Summary
Kevin Canterbury recaps that managing capital gains exposure involves understanding the basics of capital gains taxes and applying various strategies to minimize your tax liability. From taking a longer-term view of your investments, harvesting tax losses, monitoring mutual fund distributions, to hiring a financial advisor, there are numerous ways to navigate the complex landscape of capital gains taxes. The goal is not to avoid taxes entirely but to manage your exposure in a way that aligns with your financial goals and allows you to keep more of your hard-earned investment returns.
