Full Guide on How to Avoid Capital Gains Tax on Stocks

There’s no getting around it—when you sell a stock for more than you paid for it, the IRS will want its share of the profits in the form of capital gains tax. There are, however, ways to avoid paying this tax—if you know how it works. This article examines how capital gains work for stocks and how to avoid capital gains tax on stocks.

What Is Capital Gains Tax?

The profit realized from the sale of an asset is known as a capital gain—the increase in the value of a capital asset (e.g., stock) that gives it a higher worth than the purchase price. Capital gains arise when the investor sells a stock (e.g., a mutual fund or stock ETF) for more than the purchase price. For stocks, this can occur when the stock price increases over time.

For instance, if you bought 50 shares of a stock at $20 per share, and you decide to sell them later when the selling price increases to $55 per share, you’ll have a capital gain of $35 per share—or $1,750 total on all 50 shares you initially bought. After you buy and sell the stock, you pay capital gains tax on stocks on the difference between the sale price and purchase price.

How Does Capital Gains Tax Work for Stocks?

In the US, capital gains tax is a tax on profits realized from selling a particular type of asset, including stocks. Capital gains are divided into short-term and long-term, which mainly influences how the owner of the stocks will need to pay capital gains tax. The rate at which capital gains tax is applied depends on how long you have owned the assets.

• Short-Term Gain

Assets held for less than a year are taxed at the standard income tax rate.

• Long-Term Gain

Assets held for a year or more are taxed according to the long-term capital gains tax rate under the 0%, 15%, or 20% tax bracket, depending on your taxable income. The tax rate is typically lower than the standard income tax rate.

To learn how to reduce capital gains tax on stocks, you first need to understand how it works. To illustrate capital gains taxes, let’s suppose you buy a stock with an initial value of $2,000 and wait for more than a year and sell the same stock for a sale value of $7,000 when your annual income was $75,513. If you’re single, you fall under the 15% tax bracket—the total capital gains tax you must pay will be $1,243. (With the help of tax services, you can simplify the taxation process; you would be free to file taxes manually without the added expense.)

How to Avoid Capital Gains Tax on Stocks

Consider the following seven ways to minimize or even avoid capital gains tax.

• Invest in Long-Term Assets

If you plan on holding an asset for more than a year, you’ll be taxed at the long-term capital gains rate, which is lower than the short-term capital gains rate. The more you hold on to the stock, the lower the capital gains tax rate. But that’s not always up to you—some companies’ fortunes might change over the year or promptly, and you’d need to sell your stocks earlier than you had initially thought.

• Invest in Retirement Plans

You may consider investing in retirement funds or a Roth IRA to avoid capital gains tax on stocks if you’re retired or close to retirement. If you invest your money in these alternatives, it will grow without being taxed immediately. Additionally, you can buy and sell investments within your retirement plans to avoid paying capital gains tax on your assets until you decide to withdraw your money. The moment you begin withdrawing money from the traditional retirement accounts, the gains will be taxed as a standard income tax.

• Understand Your Tax Bracket

If you wish to know how to reduce capital gains tax on stocks, you need to understand which tax bracket you fall under to help you avoid capital gains taxes on your investments. If you’re in a higher tax bracket, you’ll want to hold onto your stocks longer to pay the lower long-term capital gains rate. Conversely, if you’re in a lower tax bracket, you may want to sell your stocks sooner to avoid paying the higher short-term capital gains rate.

• Tax-Loss Harvesting 

When you sell an asset for a profit, you’re responsible for paying capital gains tax on the sale. But if you sell an asset for a loss, you can use capital losses to offset your capital gains and reduce your tax liability. Tax-loss harvesting is a strategy that can help you minimize your capital gains tax liability and potentially help you in avoiding capital gains tax on stocks.

If you’re a novice investor and have no idea how tax-harvesting works, there’s no need to worry. Robo-advisors and other investment tools allow you to enroll in an automated tax-loss harvesting strategy.

• Make Charity Donations in Stocks

Donating stock directly to charity is an excellent way to avoid paying capital gains taxes on your investments. When you donate stock, you avoid paying capital gains tax on the profits from the sale of the stock. Donating to charity will not only help you sidestep capital gains tax on stocks, but you’ll also support a cause you care about.

There are two benefits of donating shares of stock. First, you’re not held liable for any capital gains taxes if there’s an increased value of the shares. Second, you get a larger tax deduction for the total market value of the shares held for more than a year.

• Reinvest in Opportunity Funds

Opportunity funds are investment vehicles that allow investors to defer or avoid capital gains tax on stocks. You can reinvest your capital gains into a new investment (e.g., real estate or business located in an opportunity zone) without paying taxes on the profits when you invest in an opportunity fund. Unless the investment in a qualifying opportunity zone is sold before December 31, 2026, the IRS permits deferral of these profits until that date. This can help you avoid paying capital gains tax on your investments.

• Hold Onto It

How long do you need to hold a stock to avoid capital gains tax? Holding on to your stocks until death is another option to avoid capital gains taxes during your lifetime. If you die while having the stock, your heirs will receive a step-up in cost basis—they won’t need to pay capital gains tax on the stock’s increase in value.

A cost basis is the cost of the investment with fees and transactions included. A step-up in the cost basis refers to the current investment value. With this option, all stocks with increased value will be exempt from capital gain taxes that otherwise would’ve been subject to taxes.

Key Takeaways

Conclusion

There are many ways to avoid capital gains tax on your investments. You can minimize capital gains tax on your stocks by investing in long-term assets, contributing to a retirement account, and even investing in opportunity funds. Hopefully, our guide has resolved any doubts you have on the topic.