How to Avoid Tax on Your Stock Market Profits

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How to Avoid Tax on Your Stock Market Profits

How to Avoid Tax on Your Stock Market Profits

A wonderful feeling might overtake you when you contemplate your stock holdings that show a profit. However, your elation might be punctured when you consider the stock market taxes you’ll pay on your profits. Before melancholy sets in, consider the available strategies for avoiding capital gains tax on shares.

Realized and Unrealized Gains

Your stocks may show a profit on paper, known as unrealized gain. Taxes are due only on realized gains, that is, profit on the sale of shares. When you postpone the sale of shares, you delay the taxes on stock gains. However, if you hold shares too long, their price might fall and wipe out your unrealized gain. Or perhaps you simply want to sell shares to redeploy your money elsewhere. Whatever the reason, you’ll keep more of your profits if you can reduce or eliminate taxes. The first step is to calculate your potential tax liability.

Cost Basis of Shares

The cost basis for a stock is the price you pay for the shares. Each purchase of shares is known as a tax lot, and you can own multiple tax lots of the same stock. You immediately adjust the tax lot cost basis to account for commissions and transfer taxes. When you sell the shares, your gain or loss is the sale proceeds minus the adjusted cost basis for each tax lot you sell. The sale proceeds are what you receive after subtracting commission costs and any other fees. Several kinds of events can occur that require further adjustments to your cost basis and that affect your taxable gains. Your broker reports your capital gains and losses from stock sales on IRS Form 1099-B.

Selecting Tax Lots

If your position in a stock consists of multiple tax lots, you can reduce your taxable gain by selling the shares with the highest cost basis first. For example, if you own 1,000 shares of stock purchased in four tax lots and you wish to sell 300 shares, you can instruct your broker which tax lots to sell. Choosing the highest-cost tax lots minimizes your taxable gain. When you receive Form 1099-B from your broker, the stock gains and losses will reflect your choice of tax lots.

Capital Gains Taxes

The profit from the sale of stock shares is taxed at capital gains rates. For shares held for less than a year, the short-term capital gains tax is equal to your marginal tax on ordinary income. As of 2020, there are seven tax rates on ordinary income ranging from 10 percent to 37 percent. However, shares held for a year or longer are taxed at the long-term capital gains rates of 0, 15 or 20 percent, depending on your income.

Treatment of Capital Losses

Capital losses can be used to offset capital gains. This provides another method to avoid taxation on your stock profits. If you can sell some stocks for losses in the same year you harvest a profit from winning stocks, you can reduce or eliminate your tax bill on your gains. You offset long-term losses against long-term gains first, and then against short-term gains. Short-term losses follow the same pattern of offsetting like gains first. Remaining losses can offset up to $3,000 of ordinary income, and any additional excess losses can be carried forward to offset future gains.

Using Tax-Sheltered Accounts

You can defer or eliminate taxes on stock market gains by trading stocks in a tax-sheltered account such as qualified retirement plan or IRA. The traditional versions of these accounts provide tax deductions for the money you contribute and allow you to earn profits sheltered from current taxes. You pay taxes, at your marginal tax rate, only on the money you withdraw, and you don’t have to start withdrawing money until you reach age 70 1/2. If you use the Roth version of a tax-sheltered account, you forego the tax deduction on contributions, but withdrawals are tax-free, as long as you observe the rules. With a Roth account, you completely avoid taxation on your stock market profits, as long you don’t withdraw earnings before age 59 1/2 or within the first five years after your initial contribution.

Contributing to Charity

Another way to avoid the tax on stock market profits is to donate your shares to charity. If you hold the shares for at least a year, you can donate them at their current value, and take a tax deduction in that amount if you itemize. Short-term holdings are donated at their cost basis, so it pays to wait until you’ve held the shares for a year. In some cases, your stock donations might help you reduce your overall tax burden by keeping you out of the next-highest tax bracket.

Tax-Free Stock Transactions

Some stock transactions are not taxable events. These include:

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  • Replacement of old shares with new ones after a merger or acquisition
  • The spinoff of a corporate division to shareholders as a separate company
  • Stock splits and stock dividends, including reverse splits
  • Conversion of preferred stock into common stock
  • Replacement of one class of common stock with another

Some of these transactions might affect the cost basis of your shares. For example, a two-for-one stock split halves the cost basis (and price) of each share. This will automatically be reflected on the 1099-B you receive if and when you sell the shares.

Taxes on Mutual Fund Shares

Many investors choose to own stocks through a mutual fund. Instead of selecting the stocks to own, you purchase a portfolio of stocks chosen by the fund manager. This is a classic way to achieve instant diversification of your holdings, thereby reducing your overall risk due to a loss on a particular stock. While mutual funds offer investors several advantages, they do make it harder to avoid capital gains tax. The reason is that each year, a mutual fund must distribute all of its realized capital gains to shareholders.

You receive capital gain distributions (which are classified as long-term) even if you haven’t sold your mutual fund shares, which would create a separate short- or long-term capital gain or loss. Automatically reinvesting the capital gain distribution in additional mutual fund shares does not diminish your tax liability. Nor does exchanging shares of one mutual fund for another.

However, the other methods of reducing taxes on stock gains can be used with mutual fund shares, including the use of tax-sheltered accounts and tax lot selling of losing positions. You can also choose to sell your mutual fund shares just before the capital gains distribution date. While this will allow you to sidestep the taxes on the distribution, it will generate a capital gain on the sale of any shares for more than their adjusted cost bases.

How to Avoid Tax on Your Stock Market Profits

Any profit you make from selling your stock is taxable by the IRS (Internal Revenue Service). It is illegal to not pay tax on the stock market profits but there are some strategies to avoid them. The following are 4 ways you can use to avoid tax on your stock market profits.

  1. Donate Your Shares to a Charity Organization

One way to avoid tax on your stock market profits is to donate your shares to charity. Doing so prevent you from having to declare your stock profits as taxable capital gain. If you sell the stock, you will be obliged to pay the capital gains tax. Donating the stock to a charitable organization also enable you to claim a deduction of the share value in the market. This method will only work for stocks that have been held for more than 1 year. If you only want to donate a small portion of your shares, you can select from the list of charity trusts of your broker. All you need to do is to donate a block of your appreciated stocks and it will be used to fund many small gifts over a span of a few years.

  1. Transfer the Stock to a Relative

Giving your stock to a relative with low tax bracket can help you to avoid tax. It will be up to the new owner to sell the stock. The new owner will be responsible for paying the tax on the stocks profits. The gains will be taxed at a rate as low as 0% in the first year when the new owner sell the stock. This only work if your relative is not a student and above 24 years old. Every year, you can give a tax excluded gift that worth up to $14,000 for per individual in your family. You must make sure that you are giving the stock to someone you trust as they will legally possess them. If you are not sure whether the person will give you the money back, you should find another person.

  1. Leaving Your Stocks to Loved Ones After Death

If you are already old, you can leave the stocks to your loved ones in the will. The fair market value of the stock at the time of your death will be used as the capital gains basis. In this way, only the increases in the stock profits beyond the date of the death will be taxed. Usually, the gains taxable on the increased value of the stock is minimal. This happens especially when the stocks are sold soon after the demise.

  1. Hold onto the Stocks in Long Term

You only pay tax when you sell the stocks at a higher price than the original price you bought. Therefore, if you don’t want to pay tax, you should hold on to your stock for long term instead of selling it. The benefit is that the stocks value may increased to a better price in the near future.

Conclusion

In conclusion, no one likes to pay tax. Every investor is looking for a way to lower tax. When the next tax season arrive, make sure you do all you can to lower tax and keep all the profits in your pocket.

How Much Tax Do I Have to Pay on Stocks If I Sell?

Make sure you know what you’ll pay before you sell your shares.

One of the best tax breaks in investing is that no matter how big a paper profit you have on a stock you own, you don’t have to pay taxes until you actually sell your shares. Once you do, though, you’ll owe capital gains tax, and how much you’ll pay depends on a number of factors. Below, you’ll learn the key factors in determining how much tax you’ll owe after a stock sale.

The basics of capital gains
Under current tax law, you only pay tax on the portion of sales proceeds that represent your profit. To figure that out, you generally take the amount you paid for the stock, and then subtract it from what you received when you sold it. If you had a loss, then not only do you not have to pay tax, but you can also use it as a deduction against other capital gains, and sometimes against other types of income. (Sometimes brokers can help you determine your capital gains — if you need one, visit our broker center.)

The tax laws also distinguish between long-term capital gains and short-term capital gains. If you’ve owned a stock for a year or less, then any gain on its sale is treated as short-term capital gain. You’ll pay the same tax rate that you pay on other types of income, and so the amount of tax due will vary depending on what tax bracket you’re in.

By contrast, if you’ve held the stock for longer than a year, then you qualify for long-term capital gains treatment. Tax rates for long-term gains are lower than for short-term gains, with those in the 10% and 15% tax brackets paying 0% in long-term capital gains tax, those in the 25% to 35% tax brackets paying 15%, and those in the top 39.6% tax bracket paying 20%.

When things get complicated
A couple of situations often arise to make tax calculation more difficult. First, the cost you use to determine gain or loss can sometimes change. For instance, if you inherit stock, its tax cost is adjusted to reflect its value on the date of death of the person who left it to you. Also, some companies make payments to shareholders that are treated as return of capital, and that adjusts your tax cost downward for purposes of calculating later gain.

The other thing to keep in mind is that there are rules for balancing out gains and losses. First, you add up gains and losses within the short-term and long-term categories across all your stock sales in a given year. Then, a net loss in one category offsets net gains in the other category. Remaining losses can be deducted up to $3,000 against other income, with an excess carried forward to future years.

Selling stock at a profit is always nice, but it comes with a tax hit. Knowing what you’ll owe can make you think twice about whether you really want to sell at all.

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