3 strategies to help reduce your capital gains tax

You’ve worked hard to build your investment portfolio — and you want to keep as much of it as possible.

While taxes from investments generally signify positive performance, they can also chip away at your overall return. Here’s what you should know about capital gains and some strategies for how to lessen your capital gains tax and increase your after-tax returns.   

What are capital gains/losses?  

A capital gain or loss represents the difference between the proceeds received from the sale of an investment and the investment’s cost basis. The cost basis is generally the original value of the investment at the time it was purchased. If an investment value decreases from the time it was purchased, it’s a capital loss; if the investment value increases, it’s a capital gain.

Capital gains arising from investment securities will only occur within taxable accounts, such as your brokerage account. Tax-advantaged accounts, such as health savings accounts (HSAs) and IRAs, are not subject to capital gains tax. If taxes apply, withdrawals from tax-advantaged accounts are taxable as ordinary income. 

How are capital gains taxed?

Capital gains and losses are classified as either long-term or short-term depending on your holding period, or length of time you own the investment. In general, capital gains are classified as long-term if you hold the investment for more than one year but are classified as short-term if they are held for one year or less.

When included on your tax return, capital gains and losses are netted together, which can result in one of the following:    

• The combined amount represents a net short-term capital gain: This is taxed as ordinary income, subject to your marginal tax rate. 
• The combined amount represents a net long-term capital gain: Long-term capital gains rates, determined based on your taxable income and filing status, will be applied to the gain and are more favorable (lower) than your marginal tax rate.
• The combined amount represents a loss: Up to $3,000 can be used to offset ordinary income, with the remainder being carried forward into future years. 

Strategies for reducing capital gains tax

Now that you understand capital gains and how they are taxed, let’s look at a few strategies for reducing your capital gains tax. It's important to note that tax strategies should not dictate investment decisions and should generally only be considered if they benefit your long-term plan.

1. Take advantage of tax-advantaged accounts.

Whether you’re saving for retirement or future health care costs, tax-advantaged accounts can help you meet your goals while reducing your tax burden. Employer-sponsored retirement accounts, such as a 401(k) or 403(b), IRAs and HSAs allow for growth on a tax-deferred basis, meaning you won’t have to pay a capital gains tax when you sell or rebalance. Be advised, however, that each account type has rules and restrictions, such as withdrawal dates or fund usage, which may result in a penalty if not adhered to.   

2. Avoid short-term gains by qualifying sales for long-term status.

If you are considering selling investments that would result in capital gains, consider selling those with long-term holding periods before those with short-term holding periods. Since short-term capital gains are taxed at a higher tax rate, it may be beneficial to hold the stock long enough for its sale to qualify as a long-term capital gain to reduce the potential tax. To do this, you generally need to hold the investment for more than one year.

3. Consider tax-loss/gain harvesting.

Tax-loss and tax-gain harvesting are strategies in which you sell some of your investments at a loss or gain to manage taxes on capital gains. Tax-loss harvesting is used to generate capital losses to offset capital gains. This can be done at any time of year to take advantage of market swings. Conversely, tax-gain harvesting is typically done when that gain will be offset by a pre-existing capital loss or when your capital gains tax rate is lower than usual. Therefore, this is usually done at the end of the year when you have a better idea of your total capital gains and losses.

With tax-loss harvesting, always consider the “wash-sale” rule, which disallows the capital loss if a substantially identical security is purchased within 30 days before or after the sale resulting in the loss. If your goal is to harvest a loss while maintaining market exposure, you can consider buying a security in the same asset class within that 30-day period as long as the security is not substantially identical. While there is no limit to the amount of losses that can be harvested, capital losses are limited to the dollar amount of capital gains recognized plus an additional $3,000 to offset ordinary income in any given tax year. Excess losses can be carried forward and used to offset future capital gains.

With tax-gain harvesting, be aware of your tax threshold for long-term capital gains. If your taxable income is below a certain threshold (in 2024, $47,025 for single filers and $94,050 for married couples filing jointly), your long-term capital gains will be taxed at 0% until your taxable income exceeds that threshold. For example, if you and your spouse file jointly and earn $100,000 in 2024, after taking the standard deduction of $29,200, your taxable income will be $70,800. The maximum amount of capital gains that can be taxed at the 0% rate is $94,050, which means you can realize $23,250 in net gains without paying any federal income taxes.

As you can tell, there is a lot to consider regarding tax-loss and tax-gain harvesting. To make life easier, you could consider an advisory program that executes some of these strategies for you. These types of programs do the work of managing your portfolio while offering potential tax efficiencies. You will pay fees for the management of the portfolio, and there is generally a minimum investment amount.  

How Edward Jones can help

Managing your tax burden is an important part of any sound financial strategy. Your financial advisor can partner with you and your tax professional to design an investing and tax management strategy to help meet your unique long- and short-term goals.