This is the second and final installment of our blog series explaining capital gains taxes.
Last week’s introduction to capital gains taxes provided background on what constitutes a capital gain. It also provided information on what qualifies as a capital asset. This week, let’s concentrate on understanding how capital gains taxes can impact your bottom line and what you can do about it.
Oh, if you didn’t read last week’s post, start there. It will help you better understand what will be covered in this post.
Short-term vs. Long term capital gains
When you sell a capital asset for a profit, it is classified as a short-term or long-term capital gain. The difference is simple. If you sell it before holding it for an entire calendar year, it’s short-term. If you sell it after holding it for over a year, it’s long-term. And even though the difference can come down to as little as one day, the potential impact on the capital gains tax rate can be significant.
How short-term capital gains are taxed
If you generate a short-term capital gain, you’ll pay a tax on the profit at your effective income tax rate. A list of those rates can be found here. Most American fall into the 22%, 24%, or 32% tax bracket. Let’s use the 24% bracket to illustrate how short capital gains tax would work in a typical situation. Pretend you bought 100 shares of Stock A on July 1, 2022, for $20,000. You sell it six months later for $30,000. Your gross profit is $10,000. But the IRS is waiting to take their cut. Since your effective tax rate is 24%, that’s what they take. So their share is $2,400 right off the top. You only net $7,600 after taxes.
How long-term capital gains are taxed
The scenario changes significantly if you hold that same stock over a year. That’s because there are only three tax rates for long-term gains: 0%, 15%, and 20% Those rates are based on your income and filing status, but most U.S. taxpayers fall in the 15% range. If we use the earlier scenario, but you are taxed at only 15%, then the tax bill is only $1,500. You take home $900 more than if you’d sold that same asset before the year was over.
Bear in mind that there are exceptions to these tax rates. So, you should consult a CPA or investment advisor whenever you sell a capital asset for a profit. One of the exceptions worth mentioning here is capital gains for homeowners. If you own a home for more than two years and sell it for a profit, you are exempt from any capital gains taxes on the first $250,000 profit as a single filer. If you are married and filing jointly, that number bumps up to $500,000. However, if you sell in two years or less, you are responsible for the total capital gains tax rate on all short- or long-term profits.
Strategies to avoid or minimize capital gains taxes
One of the best ways to minimize taxes, as illustrated above, is to hold capital assets over a year. You can also invest in tax-advantaged vehicles such as a 401(k) or an IRA. These can help you minimize taxes on your assets in the future. There’s also tax-loss harvesting, which was covered in an earlier post.
The bottom line
There’s a lot to think about on capital gains, especially if you are new to the subject. Don’t be afraid to get help from a CPA or fiduciary financial planner. And keep learning! Your financial situation and tax laws will always be dynamic, so staying on top of trends is essential. You’ll be glad you did.