Ask an advisor: How can I save my investments from capital gains tax?

Ask an advisor: How can I save my investments from taxes?

May 28, 2024 5:48 PM

In 2024, capital gains tax can claim up to 20% of an investor's profits.

Welcome back to "Ask an Advisor," the advice column where real financial professionals answer questions from real people. The topic can be anything in the world of finance, from retirement to taxes to wealth management — or even advice on advising.

Many investment accounts have tax advantages — as long as they serve a specific purpose. For retirement, there are 401(k)s and IRAs. For education, there's the 529. For health care, there are health savings accounts (HSAs). Each of these plans offers some tax protection, during either the contribution, growth or disbursement phase — or, in the case of HSAs, all three.

But what about direct, old-fashioned investments? Sometimes people simply buy shares of a stock or a fund without having a specific life goal in mind. Are there any tax advantages for such open-ended investing?

The short answer is, not really. Investments that aren't shielded by some kind of long-term account are subject to capital gains taxes, which vary according to the investor's income. For example, in 2024, a single person earning between $47,026 and $518,900 would pay 15% of their capital gains in taxes. If they earned more than $518,900, they'd pay 20%.

Is there any way around this? That's the question troubling a young engineer in Providence, Rhode Island. At age 26, he's just beginning to invest some of his savings, and not all of it is through his retirement account. How can he avoid someday handing over 15% or even 20% of his profits to the taxman?

Here's what he wrote:

Dear advisors,

I'm directly invested in an exchange-traded fund. Is there any way I can avoid taking a huge hit in taxes?

A little about me: I'm a single, 26-year-old engineer in Providence, Rhode Island. Through a Fidelity account, I have about $7,000 invested in the Invesco S&P 500 GARP ETF (SPGP). My salary is $73,000, but I expect (and hope) it will grow by the time I sell my holdings.

As far as I know, the Fidelity account is not tax-protected in any way. If I cash it out in 20 or 30 years, how much do I stand to lose to capital gains taxes? And is there any way to avoid this, or at least minimize it?

Sincerely,

Problem Solving in Providence

And here's what financial advisors wrote back:

Thinking backward

John Darby, certified financial planner at

Graham Capital Wealth Management

in Sarasota, Florida

While our young engineer is in a great spot and his head is in the right place, he's putting the cart a little bit before the horse. A majority of the tax savings and planning that can be done will be done when it comes time to distribute the account. Taking the entirety of the account in a single year is not advisable. Unless he has very specific plans on what to do with this money, he's better off liquidating the account across multiple years.

Harvest your losses

Matt Bacon, CFP at

Carmichael Hill

in Gaithersburg, Maryland

You should look for opportunities to complete tax-loss harvesting as you continue to add new money and invest. This is when you use losses on some investments to offset gains on others. Consider contributing to other tax-advantaged retirement accounts as well before contributing to nonqualified accounts for retirement savings. You're eligible to make Roth IRA contributions in addition to maxing out your workplace retirement plan. You may even be able to contribute more through a non-Roth after-tax contribution if your plan allows for it.

Right as Roth

Eustache Clerveaux, CFP at

Hudson Financial Group

in Garrison, New York

To dodge the tax hit from Uncle Sam, one strategy is to consider a Roth IRA or Roth 401(k). These gems let you invest after-tax dollars now, so your future withdrawals are tax-free. With your current income of $73,000, you easily qualify for a Roth IRA, and Roth 401(k)s have no income limits and higher contribution caps. You can contribute up to $7,000 to a Roth IRA in 2024. If your income starts to go above $146,000, you can still use the backdoor Roth IRA strategy to keep contributing, but be mindful of the pro-rata rule. Starting with Roth accounts today means you'll enjoy tax-free growth and withdrawals down the road, which will be especially sweet as your income grows.

Educate yourself

Alyson Claire Basso, CFP and managing principal of

Hayden Wealth Management

in Middleton, Massachusetts

Staying informed about tax laws is crucial. Tax laws can change, and proposals sometimes suggest increasing capital gains taxes for high earners. Keeping up to date with these changes can help you adjust your strategy accordingly.

Also, given that you're just starting out in your career and your salary is likely to grow, consulting with a financial advisor periodically can be very beneficial. They can provide personalized advice and help you adapt your strategy as your financial situation evolves. This proactive approach will ensure that when you eventually cash out your investments, you're doing so in the most tax-efficient way possible.

Less tax than you think

Jeremy Zuke, financial planner at

Abundo Wealth

in New York City

A taxable account can actually be a very tax-efficient investing account, especially with an S&P 500 funds like you have. Here are three ways you can limit the taxes on this money going forward:

Whenever you sell the funds, remember that you get favorable tax rates as long as you have held the shares for at least one year plus one day. So any gains would be taxed at a 15% rate — very reasonable relative to ordinary income taxes. And if you ever have a low-income or gap year (maybe to take a sabbatical), you might even be able to sell some or all of the funds during that year to get a 0% capital gains rate!

If you plan to contribute to a Roth IRA (which you should if you're able to!) you could simply sell the $7,000, get the cash, and put that money into the Roth IRA. You'll pay a small amount of tax now, but it will grow tax free forever in the Roth!

If you like to do charitable giving, you can give the appreciated shares to a qualifying charity (and keep the cash you would have otherwise given). That way you don't have to pay any capital gains tax, nor does the receiving charity.