Taxes

Capital Gains Taxes 101: 10 things to know

With tax season just around the corner and tax loss harvesting season rapidly approaching, here's a primer on how your capital gains taxes are calculated and how to optimize them.

Jaimin Desai

@jaimindesai93

Jaimin Desai is a co-founder and CEO of Reconcile. His mission is to help democratize access to quality tax planning through education, referrals to the best tax professionals, and software. If you ever have a question about taxes, you can find him on Twitter @jaimindesai93, and he'll make sure you get the assistance you need!

As tax season is rolling around the corner and tax loss harvesting season is quickly approaching, we wanted to share ten things to keep in mind.

It’s easy to forget about taxes or avoid thinking about them, but to be in the top tier of investors, you should always pay close attention. Taxes not only cut out a significant portion of your total return, but they can also become quite burdensome on your budget if you owe a large sum to the IRS.

With that said, here are our top ten things to know about your capital gains taxes:

1. Keep your taxes in mind throughout the year.

The IRS expects you to pay taxes as you earn income. Therefore, you can’t just think about it once a year during tax season. For investors especially, you should keep quarterly tax deadlines in mind if you’ve incurred substantial gains as you may have to pay an estimated quarterly tax or risk an underpayment penalty.

2. Taxes are sometimes paid at the local, state, and federal level.

You often have to pay state capital gains tax on top of your federal tax. Some states like California levy up to an additional 13.3% tax but others like Alaska have no tax.

Capital gains tax rates in different states of the United States of America

3. Tax benefits are given to married couples.

our base tax rate is at the intersection of your filing status (e.g. single, married filing jointly, married filing separately, head of household) and your ordinary income (i.e. money earned from working so wages, commissions, tips, etc.). Find out what your tax rates are here.

4. Optimize taxes by selling gains only after a year of holding them.

Short-term capital gains occur when you’ve held onto the investment for a year or less. Anything held for longer is considered a long-term gain. Short-term gains are taxed the same as your ordinary income, which has higher tax rates. So one should always look to minimize short-term gains and optimize long-term gains.

5. Your income is taxed at higher levels the more you make.

Capital gains are taxed on a progressive scale so every dollar is not subject to the same rate. So while your base tax rate could be 22%, if you have a large sum of capital gains, some of that may get taxed at 24%, 32%, etc. Here’s why the progressive rate provides more tax savings than a flat rate system.

 the progressive The reason why the progressive tax rate provides more tax savings than a flat rate system.

6. There’s an additional 3.8% tax for higher earners.

If your income is above a certain threshold, you are subject to an additional 3.8% net investment tax. Those thresholds are $200,000, $250,000, $125,000, $200,000 for single, married filing jointly, married filing separately, head of household respectively.

7. Be mindful of disallowed losses like wash sales.

Wash sales are a lesser-known rule that can disrupt an investors tax liability. Wash sales disallow losses if investors rebuy the same company’s stock or options within 30 days of incurring a loss. Essentially, the IRS prevents investors from booking a loss if they still intend to hold shares in the company.

8. Tax loss harvest your losses to offset other investment gains.

Tax loss harvesting is one of the most critical skills for investors to master. It helps investors limit their tax liability and boosts long-term returns.

How tax loss harvesting can result in potential savings.
Value of a Portfolio that Tax Loss Harvests

9. Losses from stocks can offset gains from crypto.

You can offset losses across your investments. So, for example, you can offset losses from your collectibles, like NFTs, against your gains from stock appreciation. Keep in mind that all the gains and losses (if applicable) in each character category are netted first within each category. So in layman’s terms, you have to first net your gains and losses within NFTs before they can be deducted from your net stock gain.

10. Specific Identification is most often the best, tax-optimized sell strategy.

When deciding how to calculate your gains and losses, you have multiple options. The most common are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), Average Cost Choosing, or Specific Identification. The former is most often used as the industry standard even though it’s the worst! For Robinhood users, unfortunately, all of your sales are processed using the FIFO method. Often, specific identification is the best strategy as it provides the most flexibility to sell your short-term losses.

With FIFO (First-In, First Out) investors are forced to sell their Jan 15 and Feb 9 lots incurring $700 gain and resulting $140 tax bill. That's the reason FIFO is bad and you should specifically identify shares to sell.

There’s your top 10! If you want to learn more about taxes, reach out to us here or follow us on Twitter.

Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult your tax professional. If you're looking to work with an accountant and need help finding someone, leave your information here, and we'll connect you.

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