Short-Term vs. Long-Term Capital Gains Tax

One of the realities of our current tax system is that we are required to pay taxes when we log gains from our investments. So, if you sell a stock, you will need to pay taxes on the gains. The good news is, that you don't have to pay taxes on this type of income until you sell and lock in the gains.

As you make the decision about whether or not to sell a stock, it can help to consider whether or not your gains are considered long-term or short-term.

This will make a difference in how you are taxed on your capital gains.

What Are Short-Term Capital Gain Taxes?

Short-term capital gains are any profits you make off the sale of an asset that you owned for one year or less. If you bought stock on July 1, 2018, and sold it for a $300 profit on March 29, 2019, that's considered a short-term capital gain. The year starts the day after you purchase stock.

Short-term capital gains are taxed at the same rate as your ordinary income. Those tax rates range from 10% to 37%. Your total taxable income amount determines which bracket you're in.

What Are Long-Term Capital Gain Taxes?

And then are long-term capital gains. These are any profits you make off the sale of assets you've owned for longer than a year. These are not taxed at the same rate as your ordinary income. And that can mean a lot of savings.

There are only three brackets for capital gains income: 0%, 15% and 20%. What this means is you'll have your ordinary tax bracket for the money you earn from your day-to-day job. And you'll have one of these three brackets for the money you earn selling your long-term capital assets.

Here's a look at the new income brackets for long-term capital gains in 2022.

Long-Term Gains vs Short-Term Gains

The amount of time you hold investment matters when figuring what you owe in terms of taxes. If you hold something for a year or less, it is considered a short-term investment. On the other hand, if you hold a stock for more than a year (one year plus one day), it is considered long-term.

Understanding this is vital as you consider taxes, since short-term capital gains are taxed as regular income, and long-term capital gains have their own tax rates.

Currently, the long-term capital gains tax is capped at 20%; if you are ordinarily taxed in the 10% or 15% tax bracket, you pay no long-term capital gains tax at all.

If you are in a tax bracket above 15%, then your long-term capital gains are taxed at a rate that is lower than your ordinary rate. If, however, you sell an investment that you have held for a year or less, the gains are taxed at your regular rate.

Before you sell an investment for a gain, it can help to consider when you bought it — at the very least you want to reduce what you pay in taxes.

First In, First Out

When you are using an investment account or selling shares in a mutual fund, it's important to understand the method of asset management used. Many are straightforward, taking a first in, first-out (FIFO) approach. This approach assumes that shares acquired first are those sold first.

So, if you sell shares in your investment account at a gain, and you want to take advantage of the lower tax rate on long-term gains, if the FIFO method is used, you only sell enough shares to correspond with what you bought more than a year ago.

You want to verify the method used, though, since some mutual funds actually take an average age of the shares to determine how long you have owned them.

This can mean that you pay more in capital gains taxes when you sell, so you should find out how your investments will be classified before you commit to sell.

Further Reading: What is Short Selling Stocks?

What About Capital Losses?

Since no stock will ever provide endless profit, there are also laws that explain how to handle capital losses.

The IRS lets you use your “net” capital loss to reduce your tax burden. Take your gains, subtract your losses, and if you end up with a net loss, you can deduct up to $3,000 annually to reduce your taxable income. (Or $1,500 if you're married and filing taxes separately.) Not only that, but additional losses can be carried into the next year to continue to offset capital gains and $3,000 of ordinary taxable income.

Getting the Most When Selling Your Investments

How long you have been holding investment matters. If you haven't held it long enough, you could end up paying more in capital gains taxes.

As you prepare your portfolio for tax season, don't forget to consider the length of time you've owned a stock. To find out more about how taxes on investments work, Check out Cofield's Concepts, an educational site from financial advisor Carter Cofield. In his tax course, you'll learn everything you need to know about how to take advantage of deductions and lower your tax bill. 

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