Long-Term vs. Short-Term Capital Gains Tax

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Many of us associate the new year with a clean slate and the opportunity for change and growth. While taxes may not be top of mind for all of us, there is truly no better time than the new year to start strategizing for next year's tax season.

Understanding capital gains tax is critical if you plan on profiting from your investments. Capital gains are profits from selling an asset. The IRS requires you to pay taxes on these gains. Only gains realized from the sale of an asset are subject to capital gains tax, while unrealized gains from appreciation are usually not taxed until you sell them.

Capital gains taxes are divided between long-term (over one year) and short-term (under one year) investments. Understanding the benefits and requirements for each can potentially save you a significant amount of money.

The Short Version

  • Long-term capital gains are any profit you make on an asset that has been sold for over a year.
  • A short-term capital gain is the profit made when you sell an asset held for less than a year.
  • The tax rates for each are different. Long-term capital gains generally have a more favorable rate than short-term capital gains. Short-term capital gains are taxed as regular taxable income.
  • How much you'll pay in taxes depends on a few factors, including your income level, and if you suffered any capital loss (i.e. if you lost money on any of your investments).

What Are Long-term Capital Gains?

Long-term capital gains are profits made when you sell assets that have been held for over one year. The long-term capital gains tax rate depends on your income tax-bracket and your filing status.

Long-term capital gains are taxed at a more favorable rate than short-term capital gains, which are taxed as regular taxable income.

Long-term Capital Gains Tax Rates

2021 Long-Term Capital Gains Tax Rates

Tax filing status 0% rate 15% rate 20% rate
Single Up to $40,400 $40,401 to $445,850 Over $445,850
Married filing jointly Up to $80,800 $80,801 to $501,600 Over $501,600
Married filing separately Up to $40,400 $40,401 to $250,800 Over $250,800
Head of household Up to $54,100 $54,101 to $473,750 Over $473,750

Source: Internal Revenue Service

2022 Long-Term Capital Gains Tax Rates

Tax filing status 0% rate 15% rate 20% rate
Single Up to $41,675 $41,676 to $459,750 Over $459,750
Married filing jointly Up to $83,350 $83,351 to $517,200 Over $517,200
Married filing separately Up to $41,675 $41,676 to $258,600 Over $258,600
Head of household Up to $55,800 $55,801 to $488,500 Over $488,500

Source: Internal Revenue Service

To use this chart, first determine your filing status. For example, let’s say you are the head of household and held a stock for over one year before selling it for $10,000 of profit in 2021. If your taxable income in 2021 is $40,000, and you had  $10,000 of long term capital gains from the stock sale, you would owe nothing on the $10,000 of long-term capital gains.

How Are Long-term Capital Gains Calculated?

Long-term capital gains are taxed by subtracting your cost basis (what you paid) from the price at which you sell the asset after one year. If this number is positive, you have a capital gain. If it is negative, you have a capital loss.

For example, if you file as single for 2021 with taxable income of $65,000 the chart above shows that you will pay 15% on long-term capital gains.

So if you bought 20 shares of XYZ stock at $5,000 in 2020 and sold them over a year later in 2021 for $6,000, you will be charged a federal tax-rate of 15% on your long-term capital gain of $1,000, or $150. This leaves you with a profit of $850.

Keep in mind that your state may charge you an additional capital gains tax, further eating into your profits.

Note: Your cost basis should typically include any commissions or fees you paid upon purchase of the asset. 

What Are Short-term Capital Gains?

Short-term capital gains are profits made on the sale of assets that have been held for less than one year. Short-term capital gains are taxed as ordinary income and thus mirror the ordinary taxable income tax rates of 10%, 12%, 22%, 24%, 32% and 37%.

Tax brackets for short-term capital gains and ordinary taxable income are also the same, while income from short-term investments usually adds to your total taxable income.

Short-Term Capital Gains Tax Rates

Tax Rates for Short-Term Capital Gains 2021

Filing Status 10% 12% 22% 24% 32% 35% 37%
Single Up to $9,950 $9,951 to $40,525 $40,526 to $86,375 $86,376 to $164,925 $164,926 to $209,425 $209,426 to $523,600 Over $523,600
Married filing jointly Up to $19,900 $19,901 to $81,050 $81,051 to $172,750 $172,751 to $329,850 $329,851 to $418,850 $418,851 to $628,300 Over $628,300
Married filing separately Up to $9,950 $9,951 to $40,525 $40,526 to $86,375 $86,376 to $164,925 $164,926 to $209,425 $209,426 to $314,150 Over $314,150
Head of household Up to $14,200 $14,201 to $54,200 $54,201 to $86,350 $86,351 to $164,900 $164,901 to $209,400 $209,401 to $523,600 Over $523,600

Source: Internal Revenue Service

Tax Rates for Short-Term Capital Gains 2022

Filing Status 10% 12% 22% 24% 32% 35% 37%
Single Up to $10,275 $10,276 to $41,775 $41,776 to $89,075 $89,076 to $170,050 $170,051 to $215,950 $215,951 to $539,900 Over $539,900
Married filing jointly Up to $20,550 $20,551 to $83,550 $83,551 to $178,150 $178,151 to $340,100 $340,101 to $431,900 $431,901 to $647,850 Over

$647,850

Married filing separately Up to $10,275 $10,275 to $41,775 $41,776 to $89,075 $89,076 to $170,050 $170,051 to $215,950 $215,951 to $323,925 Over $323,925
Head of household Up to $14,650 $14,651 to $55,900 $55,901 to

$89,050

$89,051 to $170,050 $170,051 to $215,950 $215,951 to $539,900 Over $539,900

Source: Internal Revenue Service

Federal income tax is a progressive system. If you filed as single and made $50,000 dollars in 2021, you are not taxed at 22% for the entire $50,000. Instead, you will be taxed at 10% for the first $9,950, 12% for income from $9,951 to $40,525, and 22% for the rest.

How Are Short-term Capital Gains Calculated?

Short-term capital gains could push your taxable income into a higher tax bracket, meaning that those gains would be taxed at a higher rate.

For example, someone filing as head of household in 2021 with a personal income of $50,000 made short-term capital gains of $8,000. The threshold for their tax bracket in 2021 is $54,200. Therefore, $4,200 of their $8,000 gain would be taxed at 10% and the remaining $3,800 would be taxed at 22%.

Differences Between Short-term and Long-term Capital Gains

The primary difference between short-term and long-term capital gains is that long-term capital gains are profits made on capital assets held for over one year, while short-term capital gains are profits made on capital assets held for less than one year.

Advantages and Disadvantages of Long-term Capital Gains

Below are advantages and disadvantages to consider when planning for long-term capital gains.

Advantages

  • Lower tax rate than short-term capital gains: As can be seen in the tables above, the long-term capital gains tax rate is lower than the short-term capital gains tax rates, which can make a significant difference depending on your tax bracket.
  • Potentially more passive than short-term investing: Long-term investing allows you to “set it and forget it.” Short term trading such as day trading requires investors to pay constant attention to news and movements in the market.
  • Ride out the volatility: With a long-term investment strategy, you don’t need to worry as much about sudden short term volatility in the market. If you have a long-term horizon you can wait to see if your thesis plays out.

Disadvantages

  • No quick gains: If the value of your investment skyrockets before you’ve hit the one year threshold, you can’t sell it without incurring short-term capital gains tax. You cannot take advantage of short-term market volatility.
  • Liquidity: You typically have to hold for more than one year to take advantage of long-term capital gains. That means your investments will be tied up for at least one year and you will be unable to cash out without incurring short-term capital gains if you made a profit.

Advantages and Disadvantages of Short-Term Capital Gains

It’s not always possible to incur long-term capital gains. If incurring short-term capital gains, below are advantages and disadvantages to consider.

Advantages

  • Higher liquidity: If you are planning to incur short-term capital gains tax, you can sell your investments for a profit without having to wait for it to become a long-term capital gain.
  • Take advantage of sudden volatility in your favor: Since you can sell whenever you want, you can take advantage of catalysts like news and earnings calls that move your investment in a profitable direction.

Disadvantages

  • Higher tax rate: The tax rate for short-term capital gains is higher than long-term capital gains.
  • Time commitment: If you want to take advantage of short-term market volatility or day trade, you’ll have to pay more attention to market fluctuations and news compared to investing passively for the long term.

5 Ways to Minimize or Avoid Capital Gains Taxes

For those looking to plan their taxes most efficiently, here are five strategies to consider.

1. Hold the Stock for Over a Year

Holding a stock for more than a year typically qualifies it for the long-term capital gains tax rate and can save you significant sums of money.

For example, let’s say that someone filing as single with an annual income of $60,000 made an investment of $10,000 (bought in 2020) with a sale price of $13,000 (sold in 2021). If this person sold to collect their $3,000 capital gain before the one year threshold, they would pay 22% ($660) in taxes. However, if they held the investment for over a year they would pay 15% ($450), a savings of $210.

2. Claim the Home Sale Exclusion for Your Principal Residence

Your home is considered a capital asset and is subject to capital gains tax if the sale price is greater than the purchase price. However, there is an exclusion providing that you have lived in your primary residence for two out of five years prior to its sale date. If you file as single, there are no capital gains on the first $250,000 of profit; those filing as married will pay no capital gains tax on the first $500,000.

3. Use Tax-Advantaged Accounts

Tax advantaged accounts incentivize saving long-term by reducing certain taxes you would have otherwise incurred as long as you follow the designated guidelines.

401(k): A 401(k) is a company-sponsored retirement account, potentially with company-matched contributions. Investment in a 401(k) is a tax advantage because it typically comes out of your paycheck prior to taxes (except for certain taxes such as Medicare and Social Security).

529 plan: Gains on investments put in a 529 plan for your children are usually not taxed when used for qualifying education expenses such as school tuition.

Traditional IRA / Roth IRA: IRAs are a great way to save on taxes, provided that you meet their restrictions. The primary difference between a traditional IRA and a Roth IRA is the timing of their respective tax advantages.

Find out more >>> How to Offset Your Taxes

4. Harvest Tax Losses to Offset Gains

You can offset taxes on capital gains with capital losses, a strategy known as tax loss harvesting. If you have no capital gains, you can usually realize capital losses up to $3,000 to reduce your taxable income.

5. Donate to Charitable Causes

When you donate appreciated assets to charity, you typically will not have to pay capital gains taxes. You can usually still reduce your tax liability with an income tax deduction, up to 60% of your adjusted gross income.

Things to Keep in Mind Before Selling Your Investments

When planning your exit strategy, it’s important to make sure you’ve carefully considered the tax consequences in addition to your financial situation.

If you sell stocks, be aware of wash sale rules. You have to wait at least 30 days after you sell investments before purchasing substantially similar assets. If you don't, you will lose the tax incentive. For example, if you sell XYZ stock at a loss and then buy the same XYZ stock back within 30 days, you may not be able to harvest the loss. Find out more in our wash sale rules guide.

Before selling an asset, you should consider whether the one year threshold is approaching as it could become long-term capital gains.

If you are selling a property, keep in mind that you are eligible for a capital gains tax exemption on your primary residence if you have used the property as your main residence for a total period of two out of five years from its sale date. Additionally, the cost of improvements on a property may add to your cost basis, thus reducing taxable gains.

Keep Reading >>> How to Avoid Capital Gains Tax on Your Investments

Final Thoughts

It’s important to understand the differences between long-term and short-term capital gains, as it could save you a lot of tax expenses down the line. Capital gains tax policies typically provide incentives for long-term investors. If you'd like help with efficiently planning your exits, consulting with a tax professional could be a good first move.

Disclaimer: The content presented is for informational purposes only and does not constitute financial, investment, tax, legal, or professional advice. If any securities were mentioned in the content, the author may hold positions in the mentioned securities. The content is provided ‘as is’ without any representations or warranties, express or implied.

Jay Wu, CFA®

Jay Wu, CFA®, has over a decade of finance experience spanning asset management, restructuring, and investment banking. He started Money Knock (https://moneyknock.com) to help readers navigate through the intricacies of various investment and personal finance related topics.

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