What Are Capital Gains Taxes, and How Will They Influence My Investment Strategy?
New to investing? Don’t get caught off guard by a surprise tax bill! Inside, learn all about capital gains taxes and how they might affect your investments.
October 5, 2021
They say that the only two certain things in life are death and taxes. Whether you’re earning money from a job, a business or from investments, Uncle Sam will want a piece of the action.
When you make money in the stock market, your profits will be subject to a capital gains tax. But how are capital gains taxed — and how might this tax affect your investment strategies? We’ll help you find the answers to these questions.
How does capital gains tax work?
When you sell an asset — a stock, bond, ETF, mutual fund, etc. — for more than you paid for it, the result is a capital gain.
This profit will be subject to a capital gains tax, which must be paid when you file your taxes.
Note that this tax only applies when you actually sell an investment. Simply holding an investment that has appreciated does not subject you to capital gains tax; only when you sell that asset will you owe tax.
This is a federal tax, imposed by the IRS and filed as part of your annual federal tax return. However, many states also tax capital gains — so you may be subject to federal and state capital gains taxes, depending on where you live.
Capital gains taxes are not withheld when you sell an investment. When you receive a paycheck from your employer, income taxes are automatically withheld and sent to the IRS. This is not the case when it comes to capital gains, so investors are required to set aside enough money to cover the tax when they file their income tax returns each year.
Because capital gains taxes are not withheld, they can catch some new investors off guard. It’s very important to plan ahead for these expenses.
Short-term vs. long-term capital gains tax
How capital gains are taxed depends on how long the investment is held.
Short-term capital gains tax:
Applies to the sale of investments held for less than one year.
The short-term capital gains tax rate is the same rate as your standard income tax rate. This ranges from 10% to 37%, depending on your tax bracket.
Long-term capital gains tax:
Applies to the sale of investments held for more than one year.
The long-term capital gains tax rate is either 0%, 15% or 20%, depending on your tax bracket.
Long-term capital gains are taxed favorably, often at a lower rate than your standard income tax bracket
For single filers, the rate is 0% for those earning up to $40,000 per year, 15% for those earning up to $441,450 per year, and 20% for those earning more than $441,450 per year
In general, it’s a good idea to avoid short-term capital gains where possible — this means holding investments for longer than one year before selling.
How to avoid capital gains tax
Capital gains tax will always be a factor for most investors. However, there are certain strategies you can use to minimize the tax you owe.
Use retirement accounts
In retirement accounts, like the 401(k) and IRA, gains are shielded from taxes until the funds are actually withdrawn in retirement. Investors can buy and sell assets in their retirement accounts without being subject to capital gains tax.
You will still owe income tax when funds from these accounts are withdrawn in retirement. But, because your taxable income will likely be lower in retirement, you may end up in a lower tax bracket when you do eventually pay tax on your investment profits.
Use Roth accounts
A Roth IRA or other Roth retirement account can completely eliminate capital gains taxes. With these accounts, you deposit funds that you have already paid taxes on. When you eventually withdraw the funds in retirement, you will owe no taxes whatsoever.
Hold investments for longer
If you hold an investment for at least one year before selling, you will pay long-term capital gains tax instead of short-term capital gains tax. Long-term rates are more favorable in most cases, and some lower-income individuals will actually pay 0% on long-term profits.
Speak with a CPA
If you are concerned about capital gains tax or want help minimizing what you owe, it’s worth talking to an accountant. A CPA can provide personalized advice given your situation and may be able to implement more advanced strategies like tax loss harvesting.
When selling stock, taxes can certainly eat into your profits. However, capital gains taxes are not a reason to avoid investing, or to shy away from a good investment opportunity — even if it results in a short-term capital gain. Make sure to do your research, talk to a professional and plan ahead as much as possible.
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