When I first started trading, taxes weren’t a variable I considered for two reasons. One, I was ignorant. How many 21-year-olds do you know that base their investment decisions on tax implications? Two: I lacked experience. The U.S. tax code is complicated, and it takes years of filing taxes to understand what’s going on. At least, that’s what it took for me.

But, sooner or later, you start to wise up. I’ve been around the markets for a few decades now and finally know enough to be dangerous. I’m sharing a few best practices below. These are things I wish I knew when I began.

Three quick disclaimers: I’m not an accountant, tax laws change, and contribution limits increase over time with inflation, so if you’re reading this three years from now, some of the data might be stale.

Say you buy ten shares of a $100 stock for a total investment of $1,000. Later, the stock rises to $200, and you sell your entire position for $2,000. That nets you a profit or capital gain of $1,000.

How much do you owe in tax?

The answer depends on two things.

First, was it a short-term or long-term capital gain?

Second, was the stock held in a personal taxable account or a retirement account (IRA, Roth IRA, 401k, etc.)?

Short-term vs. Long-term Capital Gains

When investing in a taxable account, you may owe taxes on any capital gains you realize. If you owned the stock for one year or less, your gains are considered short-term and will be taxed at your ordinary income tax rate. This may not sound like a big deal, but it’s a pain for those with a high income because they are taxed at their top marginal tax rate, which could be as high as 37%. And did I mention these are just Federal taxes? There are state taxes too. Here in Utah, it’s 5%. So if you’re a high roller, you’re paying $420 in taxes on that $1,000 gain. Oof!

Here’s a table showing the short-term capital gains tax rates for 2022 by filing status.

One of the unfortunate side effects of active trading in a taxable account where you’re never holding positions longer than a year is that taxes can take a big bite from your profits.

Now, suppose you owned your stock for more than a year. In that case, your $1,000 gain will qualify for a more favorable long-term capital gain.

Paying 15% instead of 22% to 35% can be a powerful incentive to wait a year before selling your stock. Not to mention the 0% rate some people might be able to land in if they have a really low income year.

If you have a large enough taxable account, you may not even need to sell your appreciated positions to access the money. Instead, you could borrow against your portfolio using a Pledged Asset Line (PAL). It’s also referred to as securities-based lending. Banks will view your portfolio as collateral against a loan they provide. You’ll have to pay interest, of course, but you won’t have to pay taxes on any capital gains because you didn’t sell anything!

Indeed, some people never sell the appreciated stock positions in their taxable accounts. When they pass on, their heirs receive the taxable account and get a stepped-up cost basis, so the taxable gain gets wiped out.

It’s a strategy known as Buy, Borrow, Die. Here’s an example:

Generation 1: Buy S&P 500 for $100k. It grows 5x to $500k by the time they die. If they sold before they passed, they would owe a bundle on the $400k of unrealized long-term cap gains. Instead, they leave it for their heirs.

Generation 2: Inherit a $500k S&P 500 position with a stepped-up cost basis of $500k. Never sell it throughout their life, but borrow against it as needed. Suppose it grows another 5x to $2.5 million. If they sold before they passed, they would owe tons in taxes on the $2 million of unrealized long-term cap gains. Instead, they leave it for their heirs.

Generation 3: Inherit a $2.5 million S&P 500 position with a stepped-up cost basis of $2.5 million. Never sell it throughout their life, but borrow against it as needed. Suppose it grows another five-fold to $12.5 million. If they sold before they passed, they would owe a bundle on the $10 million of unrealized long-term cap gains. Instead, they leave it for their heirs.

Now, at some point, there may arise estate tax issues if the amount grows too large, but you get the gist of the strategy: Buy, Borrow, Die.

Another idea for reducing the tax burden of appreciated long-term positions is to donate them to charity instead of paying cash. Then re-buy what you just donated with the cash you would have donated. It wipes out the taxable gain while maintaining your position. For example, suppose I bought 100 shares of a $50 stock for $5k. Now, the stock is at $100, making my position worth $10k with a $5k unrealized gain. Donate the $10k in stock and then take the cash you would have donated and rebuy the 100 shares at $100. Your taxable gain is gone, and you still have your $10k stock position.

Another factor influencing the tax situation of your stock investment is the account type you’re investing in.

Account Types

Fundamentally there are 3 types of accounts from a tax perspective: taxable, tax-deferred, and tax-free. We’ve already hit on the first one. Let’s cover the final two.

Tax-Deferred

This bucket includes 401k, 403b, TSP, IRA, SEP-IRA, SIMPLE-IRA, and others. You invest pre-tax money into these, so they reduce your tax burden today. They grow tax-deferred, which means you don’t have to pay taxes on capital gains, dividends, or interest along the way. Then, when you’re older (as of 2022, it’s age 72), you will have to pull money out each year that will be taxed. There’s a formula that determines how much you must withdraw, and it’s called a Required Minimum Distribution (RMD). These are taxed as ordinary income, which is a bummer- especially if you don’t need the money.

If you’re in a high tax bracket and need to reduce your taxable income, these come in handy. In the case of a 401k, many employers match the dollar amount you invest up to a certain percentage of your income. So you can get an immediate 100% return. it’s free money. Take it if it’s available.

There are a few strategies you can use with these account types.

First, you can donate the required minimum distributions to charity if you don’t need the money that year. It’s known as a qualified charitable donation or QCD.

Second, if the market crashes at some point along the way and your tax-deferred account gets whacked, you can consider converting some of it into a Roth IRA while the account balance is lower. That reduces the tax owed versus if you waited for the market to recover and your account balance was far higher by the time you hit age 72.

Tax-Free

These are known as ROTH accounts, and the most common is a ROTH IRA. I’ve used these since I was a wee lad and continue to shovel money into them when possible. The money grows tax-free, meaning you NEVER have to pay taxes on capital gains, dividends, or interest. The contribution limit for 2022 if you’re under 50 is $6,000 but rises to $6,500 for 2023. If you’re over 50, it bumps up to $7,000 and $7,500, respectively. You must have earned income to contribute to a Roth IRA, but you can invest in one for a non-income-earning spouse. Unfortunately, if you make too much money, the government doesn’t allow you to use a Roth IRA.

Here are the income limits for 2022:

There is a workaround known as a BackDoor Roth IRA, but it’s not applicable to everyone. Consider this your nudge to investigate it if you’re curious.

Those strategically using all three will have some nice tax diversification come retirement. Being able to draw your income from taxable, tax-deferred, and tax-free accounts provides flexibility and allows you to efficiently sell down assets in whichever accounts make the most sense, given your tax bracket.

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