Taxes can eat up a big chunk of your capital gains, and they really affect the long-term effect of compounding.
The good news is that there are steps you can take to minimize the taxes you pay on stock gains. The tax regulations are different from country to country, and I’m trying to generalize, but most of the examples that I use are from the US tax system.
Let’s get cracking. Here are a few things you can do.
1. Maximize Your Contribution to Accounts that Offer Tax Advantages
In most countries, there are some kind of savings accounts that give you tax advantages.
These could be 401(k) plans where you can contribute a part of your paycheck before taxes, thereby reducing the amount you have to pay taxes on (if you are self-employed, the equivalent is a SEP IRA).
This could also be a Roth IRA that lets you contribute money you already paid taxes on, where your money can grow tax-free. In other words, putting money into an Roth IRA doesn’t reduce your taxable income the year you make the contribution, but you get a tax benefit on the back end.
The UK equivalent would be an ISA account.
These types of accounts have a different name in every country, so you should research your options and take advantage of them. You might want to call an accountant or call your local tax authorities to learn what accounts that offer tax advantages are available to you.
2. Invest Long-Term
If you don’t sell your stocks, you don’t pay taxes on them.
Did you know that Warren Buffett pays a lower tax rate than his secretary? How come one of the richest men in the world doesn’t pay a lot in taxes?
That’s because Warren Buffett doesn’t sell shares.
Warren Buffett’s income is actually very modest. His annual salary from his company Berkshire Hathaway is just $100,000 a year, and his secretary is rumored to make at least $200,000.
Warren Buffett’s wealth comes from holding just one stock: Berkshire Hathaway, and he doesn’t sell it – which means he pays no taxes on his accumulating personal wealth.
Some countries give you a more favorable treatment if you are a long-term stockholder. In the US, you pay regular income tax on a stock you hold for less than one year. If you hold it for one year and a day or more, you pay capital gains taxes, which are lower than regular income taxes.
3. Combine Gains and Losses Strategically
If you have an investment that has gone bad, you can sell it off strategically to offset capital gains.
If you sell shares with a loss in your taxable brokerage account, that loss can help offset other short-term or long-term gains.
How does that work? In most countries, you only pay taxes on your net gain (the amount you have realized in gains minus your losses). So if you know you have some realized gain, you have an opportunity to realize some losses too to offset that gain. This is called tax harvesting.
Of course, you don’t want to have any losing position on purpose just to avoid taxes, but if you happen to have an investment that didn’t go as planned, you can be strategic about when you sell it.
4. Structure Your Investment for Tax Efficiency
On some accounts, you don’t pay taxes, and on others you do.
You can position your investments so you get the best of each system.
Why not place the very long-term investments in your taxable brokerage account where you only pay taxes when you sell them?
Why not place dividend paying stocks or short-term investments in your Roth IRA, where you don’t pay taxes?
Don’t Let Taxes Overshadow Your Investment Strategy
You should buy or sell investments based on your belief that they will gain or lose value over the long term. Don’t make investment decisions just to reduce your tax burden.
Taxes are a luxury problem. If you pay taxes, it means you’ve made money. Don’t forget that. Be grateful for it.
Also remember all the things you contribute to with your taxes. Like my uncle used to say, “I pay my taxes with gratitude.”
I’ve thought a lot about that during the COVID-19 pandemic.
I live in a country (Denmark) with one of the highest tax rates in the world, but also in a country with one of the best free healthcare services in the world. I’ve been fortunate enough to feel safe throughout the pandemic – and that means a lot when you have small children.
I try to pay my taxes with gratitude and think of how I contribute to society.
Don’t forget the e-book Free Yourself. It’ll teach you how to calculate how much a company is worth. You can get it for free here.