Whenever you earn money, the government wants its cut. This is true whether you’ve made money by working for someone else, owning a business or investing.
With investing, you can shield some of your earnings (at least for a time) by using a tax-advantaged retirement account like a 401(k) or a traditional IRA. If you have a Roth retirement account, you can completely avoid paying tax on your investment earnings.
However, there are limits to how much you can contribute to these accounts, as well as restrictions on when you can access your money.
In some cases, it makes sense also to have a taxable investment account. Once you sell assets in a taxable account, however, you need to be aware of the tax consequences.
What Are Capital Gains?
Anytime you profit from selling an asset; it’s a capital gain. This applies no matter what asset you’re selling, from stocks and bonds to artwork, to a classic car. Even real estate sales come with capital gains. All of these profits need to be reported to the IRS – and taxed. (Selling your residence, however, comes with a capital gains tax exclusion.)
For example, let’s say you buy 100 shares of stock XYZ for $10 per share, or $1,000 total. Later, you decide to sell those 100 shares when they are worth $30 per share, for a total of $3,000. Your profit, or gain, is $2,000 – the difference between what you paid for the stock and the amount you received for selling it.
Anytime you sell something for more than you paid for it, you’ve realized a gain. It’s important to note that this applies to digital assets, including cryptocurrencies, as well as tangible assets, such as real estate.
Long-Term Capital Gains vs. Short-Term Capital Gains
Capital gains are categorized as long-term gains or short-term gains. It’s important to understand the difference because these gains are taxed at different rates.
- Long-term capital gains are those held for more than a year. You need to hold an asset for a year and a day for it to be a considered a long-term investment.
- Short-term capital gains are those held for a year or less.
When planning your investments and trying to figure out how to move forward, it’s important to consider long-term and short-term gains and how they’re taxed so you get the most efficient tax treatment possible.
Understanding Capital Gains Tax Brackets
This is where the rubber meets the road. You need to figure out how much you’ll pay, based on your profits.
With short-term capital gains, you’ll pay tax at your regular income rate. So if you’re in a higher tax bracket, that’s the rate you’ll see with your short-term capital gains. Your tax bill can get quite steep if you’ve seen substantial gains during the year.
On the other hand, long-term capital gains come at a more favorable rate. You’re taxed on them at a lower rate. In general, the government likes to encourage long-term investing rather than short-term speculation. As a result, investors who hold their assets for a longer period enjoy more favorable tax treatment.
Your long-term capital gains rate depends on your income and filing status. In 2019, here’s what you can expect to pay if you hold your assets for more than one year:
|Rate||Single||Joint||Head of Household|
|0%||Up to $38,600||Up to $77,200||Up to $51,700|
|20%||More than $425,800||More than $479,000||More than $452,400|
As you can see, if your income falls within a certain range, you don’t have to pay any tax on your long-term capital gains. If you do end up paying capital gains tax on your long-term assets, your rate will be lower than your marginal rate. Many wealthy people structure their finances in a way that allows them to take advantage of the favorable capital gains rate.
Collectibles Are Taxed Differently
You need to be aware that some assets fall into the category of “collectible.” These assets have a long-term capital gains tax rate of 28%. Some items that are considered collectibles include:
- Rare coins
- Rare books
- Rare stamps
- Baseball cards
- Fine wine
- Some jewelry
- Classic cars
Also, note that profits from gold and silver bullion and certain gold and silver coins are taxed at the collectible rate.
For those in higher tax brackets, the long-term collectible rate is still favorable. However, for those in a tax bracket lower than 28%, it can make sense to sell collectibles within a year and pay tax at the regular rate.
Because collectibles don’t really add much to economic growth, the government doesn’t see a need to treat these items with the same favor as long-term investments in stocks or real estate.
How the Capital Gains Tax Works
Let’s say you bought your $1,000 worth of stock and then sold it eight months later for $3,000, making a profit of $2,000. If you’re in the 24% tax bracket, you’ll pay $480 tax, for a total net gain of $1,520.
What if you decide to wait just a little bit longer? You sell a few months later to claim a long-term profit rather than a short-term profit. Now your stock is worth $3,500, leaving you with a gain of $2,500. Your tax bill at the long-term rate of 15% is $375. That’s right: You’ve made a more significant profit, but you’re paying less tax because of the favorable rate. Now your total profit is $2,125.
With the favorable long-term capital gains rate, you get to potentially take advantage of further gains and compound those with a lower tax rate. Watch your wealth grow more efficiently by combining the favorable tax rate with the potential to boost your profits by letting your asset appreciate a bit longer.
What If My Investment Loses Value?
When your investment loses value, it’s called a capital loss. You don’t have to pay tax on capital losses since you don’t see a net benefit. In fact, it’s possible for you to use capital losses to offset your capital gains, allowing you to reduce your tax further. A portion of your losses can even be used to reduce the tax on your regular income.
Consult with a tax professional to get an idea of how to use capital losses to your advantage by offsetting gains. Also ask how to coordinate your investment portfolio for maximum tax efficiency between your tax-advantaged retirement accounts and your taxable investment accounts.
Investing is a great way to build wealth, allowing you to take advantage of capital appreciation. However, the government still wants its cut. Paying tax on your gain is a reality that you need to consider as you build your portfolio. Balance different types of investments in a way that makes the most financial sense for you.
Carefully consider when to sell your assets so that you get the most significant advantage. The more money you keep, the more you have to use for what you want. That’s better than sending it off to Uncle Sam.