4 Ways You Can Deal With Capital Gains Tax Increases

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4 Ways You Can Deal With Capital Gains Tax Increases

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Ever since President Biden proposed to raise taxes on capital gains, many investors started sweating. If you’re one of them, hold on a minute. Before you make any regrettable decision with your own portfolio, it’s important to check first if you’ll be among those affected, because not everyone will be.

If you own investments you’ll want to leave to your heirs, you should first get a better understanding of the possible change in estate tax treatment that could mean a higher tax bill for your loved ones. Why? Because it could be somewhat avoidable if you take the right actions.

Manage your capital gains taxes

Before we start talking about possible changes, let’s recap what capital gains taxes are. Capital gains taxes are taxes levied on profits from selling an investment.

For example, if you buy $5,000 in stock and sell those shares five years later for $10,000, you will have to pay taxes for that $5,000 gain, unless the investment is held in a tax-deferred account, like a 401(k) or IRA. President Biden’s proposal was to raise the tax rate to 39.6%, from a top of 20% currently.

But don’t panic, this will only affect the investors earning more than $1 million a year, so most people won’t be affected. Also, the proposed changes might evolve in time, due to the legislative process. If you get affected by these changes, here’s what you can do:

  1. Invest in municipal bonds – They are usually exempt from federal income tax, but also from state income taxes if the bond issuer is from the investor’s home state, making them appealing to investors in high-tax states. Even so, you can also consider out-of-state municipal bonds, because they will provide portfolio diversification, but also higher after-tax yields.
  2. Max out what you contribute to your tax-deferred retirement accounts – We’re talking about your 401(k) and IRAs, as any capital gains you earn from investments in these accounts will postpone any tax until you begin withdrawing the funds in retirement.
  3. Use tax-loss harvesting to lessen the tax bite from capital gains – You can sell an investment that’s fallen in value and use the loss to reduce your taxable gains. Later, you can reinvest your proceeds into a similar investment, to maintain your asset allocation. Only $3,000 of capital losses can be used to offset ordinary income over and above offsetting any capital gains in the same tax year, so any remaining losses can be carried forward in the future, indefinitely.
  4. Consider investing in separately managed accounts – They are also called SMAs, and they come as an alternative to mutual funds. Fund investors are often surprised to receive taxable gains statements at the end of the year, whether or not they sold any shares. SMAs have no embedded capital gains, unlike mutual funds. To add up, an investor who invests in an SMA owns the portfolio’s securities directly, so they can take advantage of tax-loss harvesting.

President Biden’s proposal also mentions the following: when someone passes away, their death would trigger capital gains taxes on appreciated assets for their heirs.

This can happen either at the time of their death or when their heirs decide on selling the assets. So, to put things into perspective, if you inherited shares worth $200,000 that had been purchased for $20,000, you’d owe capital gains on the $180,000 worth of appreciation.

Tax laws are always going to change, as they are evolving. And the proposal’s journey can change everything by the time it becomes law. No matter what may happen with taxes, you should take into consideration to meet with your financial adviser.

Every year comes with many new developments, and asking for an opinion on these matters is the best thing to do.

If you enjoyed reading this article, we also recommend you: Do You Have to Worry About Biden’s Taxes? Only These 9 Groups Should!

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