In today’s post, I’ll be breaking down the hot topic of capital gains tax.
We’ll discuss how capital gains tax applies to short-term and long-term gains and, of course, how it affects your overall tax liability.
What are capital gains?
Capital gains are the profits you make from selling assets at a higher price than what you paid for them. These assets can be stocks, bonds, real estate, and other types of investments.
In general, when you sell an asset and make a profit from that sale, then the capital gains tax is applied to the amount of profit you made. For example, let’s say you bought a stock for $1,000 and sold it for $1,500. The capital gains tax would apply to your $500 in profit.
How much tax you’ll pay on that $500 depends on several factors, such as your income, the length of time you held the asset (short-term vs long-term), and the type of asset you sold. It’s important to understand how capital gains tax will apply to your investments and profits so you can really understand your overall investment portfolio and how to maximize its growth.
What is the difference between short-term and long-term capital gains?
Short-Term Capital Gains
Short-term capital gains are profits you’ve made on an asset you’ve held for less than a year. You can think of short-term capital gains like fireworks. They’re quick, exciting, and burn out quickly.
Pro:
- Instant Gratification: Short-term gains put money in your pocket faster, so you can use that money sooner.
Cons:
- Higher Tax Rates: Usually, short-term gains are taxed at your regular income tax rate, which is determined by your tax bracket. This rate ranges between 10% and 37% and can be quite a bit higher than the long-term capital gains tax rate.
- Volatility: Short-term investments can be a rollercoaster ride because while you might end up with a gain, you could easily end up with a loss.
Long-Term Capital Gains
On the other hand, long-term capital gains are the profits from investments you’ve held for longer than one year. These are like an old bottle of wine; they get better with time.
Pros:
- Lower Tax Rates: Obviously, from a tax standpoint, the biggest pro to holding long-term investments is that you’ll pay a lower tax rate on those profits. The vast majority of taxpayers will have their capital gains taxed at the 15% rate.
- Steady Growth: Long-term investments are typically more stable and provide the opportunity for your money to flourish and grow steadily.
Cons:
- Patience Required: You have to be willing to play the long game, so your money may be tied up in the investment for longer than you’d like.
- Market Risk: Even though long-term investments are typically more stable than short-term investments, your money will still face market fluctuations. So you could still end up with a loss instead of a gain.
Are long-term capital gains always better than short-term capital gains?
As you can see from the descriptions above, both types of gains have pros and cons. Which type of investments you choose should correspond with your financial goals and situation.
If you’re in it for the quick thrill and can stomach higher taxes and risks on certain investments, then short-term gains could win the day.
But if you’re looking for a financial plan that revolves around building wealth over time and paying less to the taxman, then long-term gains will work best for you.
Of course, when thinking about your financial plan, you should consult with a certified public accountant who can help you see the big picture and determine how much capital gains tax will apply to your particular investments.
Can I avoid paying capital gains tax?
The short answer is no, you can’t completely avoid paying taxes on profits you make from capital gains. However, there are some legal ways to minimize how much you owe for capital gains tax:
- The easiest way to minimize how much you pay in capital gains tax is to simply hold onto your investments for longer than one year.
- You can also leverage your investment losses to offset your capital gains. When you do this intentionally, it’s called “tax loss harvesting,” and I’ve written a dedicated article to explain this tax-saving strategy.
- Another option is to use tax-advantaged accounts like education and retirement savings accounts to buy and sell other investments. This strategy could make it possible for you to buy and sell other investments without paying capital gains tax on profits from those investments.
How do I pay capital gains tax?
Typically, you’ll report your capital gains on your annual tax return. You’ll reconcile your gains and losses on Form 8949. Then, you’ll report those subtotals on your Form 1040 Schedule D.
Keeping track of your investments and how they’ll be taxed is an important element of investing. If you have questions about capital gains tax and how you can minimize your tax burden, contact a tax professional for support.
