Earned income is the hardest income to protect from financial predators and we need to do all we can to reduce our tax burden. One of the best ways to do this is to use your taxable investing account as tax efficiently as possible. This article will enable you to do just that.
For most of the history of the income tax, long-term capital gains have been taxed at lower rates than ordinary income. The maximum long-term capital gains and ordinary income tax rates were equal only in 1988 through 1990 and this may again occur if Biden’s wealth tax becomes a reality. According to the current tax code, if you have 1 million dollar in capital gains it will be taxed to the maximum of 20% or so no matter your income. With the purposed tax plan anyone earning over $1 million of earned income would have to pay 37% tax on ever single dollar of long term capital gains. That’s almost double the long term capital gains rate.
This then begs the question. Why on earth would anyone want to pay short term capital gains tax, which is taxed as ordinary income, when the benefits of long term capital gains tax is so good? Well, speculators and short term traders do this all the time and this is a tax inefficient way to use a taxable investment account.
For example, You shouldn’t day trade in a taxable account if you are going to generate significant capital gains. If you want to day trade and produce significant short term capital gains then do so in a pretax account like a 401K, 457, or IRA. You can even use a post tax account like a Roth IRA or Roth 401K, or Roth 457. This would be the best tax efficient way to deal with short term capital gains. On the other hand, if you are likely to lose money with day trading, which is usually the case, then it would be best to day trade in a taxable account, because you can then deduct the capital losses form your income or from capital gains from other transactions.
Taxable investing accounts in my book should be used for long term capital gains primarily with the harvesting of capital losses a secondary benefit. Short term capital gains should never happen in a taxable investing account period. For example, you should never sell a stock for short term capital gains because you need the cash. That is what an emergency fund is for. This is yet another reason why an emergency fund is always a prerequisite to investing in the stock market. We all have to realize that there is a difference between saving and investing. Your savings should never lose money, but your investment represents a portion of your savings that you are willing to put at risk and potentially lose. Conservative wealthy people do not put any of their savings at risk. Moderately wealthy people put 25 to 50% of their saving at risk and aggressive wealthy people put 50% or more of their savings at risk. Your savings is your emergency fund and whether you want to have a 3 to 6 months emergency fund or invest 75% of your savings is subjective, but you should always have savings that is separate from investment dollars. This is because saving always comes before investing. There is no investing without first saving money. Don’t skip this step.
Your taxable investing account should be used to limit taxes by taking advantage of long term capital gains and to reduce your tax burden by harvesting and taking advantage of capital losses. This is best done with a buy and hold long term investing strategy. This is impossible to do as a stock market trader where you are dipping in and out of the market whether it’s daily, weekly or monthly. You only have to hold stocks for a year to reap the benefits of long term capital gains. To some this may feel like an eternity, but with a buy and hold investment strategy where you are holding each stock purchased for a minimum of five years with a preferable 10 to 15 year holding period, then achieving long term capital gains treatment is just a drop in the bucket.