What to know about your capital gains taxes

What to know about your capital gains tax?

A quick overview on taxes!

What is the capital gains tax?

The profit or loss that results from the sale of an asset is often referred to as a capital gain or a capital loss. Assets can be anything from investments, like stocks and bonds, to physical land. Anytime money is made on the sale of an asset, profits are subject to something called a capital gains tax. Capital gains are classified as either long-term or short-term depending on how long the asset is held before being sold. The length of time an asset is held in conjunction with a couple of other factors will determine an investor’s capital gains tax rate.

How to calculate your capital gains tax

A few factors determine the rate at which capital gains are taxed: how long the investment was held before being sold, the investor’s income, and the investor’s tax filing status. If an investment is held for less than a year, it is subject to the investor’s federal income tax, which is less favorable than the long-term capital gains tax. If an investment is held for more than a year, an investor’s income and tax filing status will determine which of the three capital gains tax rates apply: 0%, 15%, or 20%.

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Long vs. short-term capital gains taxes

The amount of time an investment is held has a large impact on its capital gains tax. Short-term capital gains tax rates apply to assets that are sold after being held for less than a year, while long-term capital gains tax rates apply to assets that are sold after being held for more than a year. As mentioned, short-term capital gains taxes are equivalent to an investor’s income tax rate. While the difference between an income tax rate and capital gains tax rate may seem minor, it has large financial implications. A long-term capital gains tax rate can either be 0%, 15%, or 20% based on annual income and marital status, whereas the federal income tax rate can fall anywhere between 10% to 37%. Within any income and marital bracket, a person will earn more after a capital gains tax than they would after a federal income tax.

How they impact investors

Capital gains taxes are often taken into consideration when investors think about where to invest their money and when to sell securities. Certain retirement and education investment plans present tax benefits for someone interested in creating a long-term investment portfolio. For example, if investors set up a 401(k) retirement plan, a traditional Individual Retirement Account (IRA), or a 529 education plan they can buy and sell investments within a tax-free environment. While there is often a tax upon withdrawal from these accounts, it is still extremely beneficial and efficient to build a long-term portfolio within a tax-free environment.

If investors decide to buy and sell securities within a traditional investment account, they will often hold on to stocks for longer than a year to avoid the unfavorable income tax on short-term capital gains.

Bottom line

Many investors take the potential impact of a capital gains tax into account when deciding how to handle their investments. An investor’s long-term capital gains tax is more favorable than an investor’s federal income tax, regardless of income or filing status. Therefore, investors may decide to hold on to securities for longer than a year to reap the benefits of the lesser rate associated with a long-term capital gains tax. Some investors who are trying to build a long-term portfolio may opt to avoid short-term taxes by setting up a retirement or education account. All investors want to ensure that their investments are as profitable as they can be. To do this, it is necessary to think about the effect of taxes on capital gains.