Becoming a Better Investor Through Tax Optimization

When we talk about good investing, too often we focus on the ability to pick stocks and index funds. And while this is important, it overlooks one of the most underappreciated differences between good and great investors: optimizing taxes. Understanding capital gains can easily cut your investment tax bill in half — and sometimes it’s just a matter of holding an investment for a few more days.

Capital gains are profits generated from selling assets for a profit. Beginning with the Revenue Act of 1921, the U.S. government introduced short- and long-term capital gains taxes as a way to encourage long-term investments that provide market stability and encourage economic productivity. Here are the basics to understanding how these taxes work for equities in brokerage accounts (retirement accounts have different rules):

• You only incur taxes on investment once you “realize” the profit or loss. That means once you sell the investment. Taxes are calculated on an annual basis and your gains are netted from losses (more on that later).
• If you realize the gain on an investment in less than a year, you pay a higher tax called a short-term capital gain tax. This is usually the rate of your marginal ordinary income tax. “Marginal” is a big deal here, because that means the highest rate you pay, not the effective tax rate.
• If you realize the gain after more than a year of holding the asset, then you pay a lower tax rate called the long-term capital gains rate. This rate is either 0%, 15% or 20%, depending on your income tax bracket.
• For example, if you filed alone in 2022 and made $180,000 in income, you would pay a short-term capital gains rate of 32%. But if you held that same asset for more than a year, you would pay only 15%. That cuts your tax bill in half!
• Similarly, if you are married and have a joint income of $80,000, you would pay a short-term capital gains tax of 12% but a long-term capital gains tax of zero!

There’s another critical element to understanding capital gains: offsetting gains and losses. You calculate capital gains tax at the end of a year, based on your net taxable gains and losses. This is important since losses can be used to offset gains and reduce tax liabilities. If losses exceed gains, up to $3,000 can be used to offset ordinary income, and any excess losses can be carried forward to offset future capital gains in future years, $3,000 per year max.

Many investors overlook the importance of capital gains taxes when making investment decisions. This oversight can lead to unnecessary tax liabilities, reducing net returns and hindering long-term financial goals. Xillion’s Portfolio Optimizer is designed with capital gains in mind. We help users find index funds designed for a buy-and-hold strategy, reducing taxable events on the path toward financial independence.

So next time you are preparing to execute an order, keep in mind the tax implications. Investing isn’t just about being in the highest-returning asset all the time — it also depends on your current portfolio and the tax implications of moving money into a new asset.