Once you start investing, you’ll run into investing terms like “capital gains” and “capital losses.”
If you’re a newbie, it’s easy to gloss over these phrases. But if you want to maximize your tax situation and avoid problems in the future, understanding how capital gains and losses work is vital.
What are capital gains?
Simply put, capital gains represent the positive difference between what you paid for an asset and what you sold it for.
Say you buy 100 shares of stock for $5 a share. Your initial investment is $500. Fast forward three years and that stock is now worth $20 a share. You decide to sell all 100 shares and end up with $2,000 in your pocket.
Not all of that is profit, though. Subtract the initial $500 investment and your capital gains amount is $1,500.
This process also works if you sell just a portion of your 100 shares. If you only sell 50 shares, you get $1,000. However, the original cost you paid for those 50 shares was $250 (at $5 a share). In this instance, your capital gain is $750.
Whether it’s a stock, bond, fund, or even a collectible like artwork, you need to figure out whether you’ve made money when you sell an asset. If you have, it’s a capital gain.
What are capital losses?
As you might expect, a capital loss is the opposite of a capital gain. If you sell an asset for less than you paid for it, that’s a capital loss.
What if you buy 100 shares of stock for $5, but the price later drops to $3 a share? If you sell those shares at that price, you’ll only earn $300 on the sale. That’s a capital loss of $200.
One reason that some experts suggest you “ride out” stock market crashes is due to the fact that if you sell during a drop, you lock in your losses. That’s why some people lost so much during the 2008 crash: They panicked and dumped their investments, securing their losses.
If you have good investments, they are likely to recover from temporary setbacks. However, part of being a savvy investor is learning when to cut your losses and move forward.
Long-term vs. short-term capital gains
Now that you know what capital gains and losses are, it’s important to understand whether or not they are long-term or short-term. This matters when it comes to taxes; the tax rate you pay depends on how long you’ve held the investment.
A long-term investment has a favorable capital gain tax rate. When you hold an asset for a year and a day, it’s considered long-term. If you hold an asset for a year or less, it’s considered short-term.
The IRS requires your broker to provide you with information about your investments and they will send you a 1099-B at the start of every year. This form will list your gains or losses for the last year. You’ll also see which ones are long-term and which are short-term.
Capital gain tax rate
The IRS expects you to pay taxes when you see an increase in circumstances. If you sell an investment at a gain, you’re taxed on that — but your capital gains aren’t always taxed the same way as the rest of your income.
Capital gains taxes on short- and long-term income
When you have a short-term capital gain, it’s taxed as ordinary income. You pay taxes in line with your tax bracket.
Long-term capital gains are taxed at a more favorable rate based on your regular income:
- 10 to 15 percent tax bracket: 0 percent
- 25 to 35 percent bracket: 15 percent
- 39.6 percent tax bracket: 20 percent
When you hold investments for longer than a year before selling them, your gains are going to be taxed at a lower rate than your bracket.
Capital gains taxes on collectibles
The exception to the tax rules above is when you sell collectibles. If you have the collectible for a year or less, you are taxed at your normal rate. However, if you have the collectible for more than a year, the rate is 28 percent.
Put simply, if you’re in a lower tax bracket you can be penalized with a higher rate when you sell a long-term collectible. Those in higher tax brackets still receive a tax advantage by paying a lower-than-normal tax.
Collectibles include rare items (books, stamps, coins), art, baseball cards, fine wine, and antiques. Precious metal coins and bullion are also considered collectibles.
Do you pay a capital gain tax rate on investments in tax-advantage accounts?
If you have your investments in a tax-advantaged account such as an IRA or 401k, you don’t have to pay capital gains tax immediately.
With a traditional retirement account, you pay taxes when you withdraw your money. However, the money you withdraw is taxed at your regular rate — no matter how long it’s been sitting there.
When you have a Roth account, you don’t have to pay any taxes on the income you withdraw. You make contributions with after-tax money and it grows tax-free. You don’t have to worry about capital gains at all.
What does a capital loss mean for my taxes?
Here’s some good news: You can take a deduction for investment losses. This can be used to your advantage if you can use your capital loss to offset your capital gain. That makes your capital gain smaller, meaning you pay fewer taxes.
If your losses are greater than your capital gains, you can take the excess and deduct it from your regular income — up to $3,000 a year for joint filers. Even better, if your excess loss is more than $3,000, you can carry the difference forward to another year.
Say you have $1,000 in capital gains and a capital loss of $5,000. You use the first $1,000 to offset your gain. Now you don’t owe any taxes on your capital gain, but you still have a loss of $4,000 to deal with.
Take $3,000 of that and deduct it from your regular income. What about the $1,000 left over? You can’t use it this year, but you can carry it forward to next year.
The government likes to encourage long-term investments in businesses and other forms of economic expansion. When you invest long-term, it’s considered a plus for the economy; that’s why your gains are taxed at a lower rate and your losses can be used to offset your income.
Not sure how to best use capital gains and losses as part of your tax strategy? Consult with a tax professional.
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