What Is a Capital Gains Tax, and How Does It Work?
Capital gains taxes are taxes paid to the Internal Revenue Service for profits from the sales of various assets. But how capital gains taxes work can be complicated. Continue reading this article to learn more about them.
What Is a Capital Gains Tax?
When you sell capital assets like stocks, bonds, real estate, and cars, the profits are considered taxable income. It’s important to note that capital gains taxes are only applicable upon selling assets, not as you hold them. So if a stock you’ve invested in sees a dramatic price increase, you won’t owe any income taxes on those gains so long as you don’t sell any of your shares.
To calculate your capital gains, you take the total sale price of the asset and subtract the original amount you paid for it. Let’s say, you bought an investment property for $500,000 and five years later sold it for $750,000. Your capital gains amount to $250,000.
There are two different types of capital gains, both of which are taxed by the federal government. Let’s take a look at the differences between them:
Short-Term Capital Gains
The profits made on an investment that you’ve held for less than a year are called short-term capital gains. Short-term capital gains are taxed as ordinary income, which is a higher rate than long-term capital gains. Because of this, you typically want to hold on to your investments for longer than one year.
Long-Term Capital Gains
Long-term capital gains taxes are applied to investments that you held for at least one year. You may pay little or no capital gains taxes, depending on your income. However, tax rates on capital gains of this type can be up to 20%. We’ll go more in-depth on this in the next section.
Why Are Capital Gains Taxed Lower for Long-Term Investors?
Short-term stock trading creates market volatility and increases the number of risks investors and businesses face. To help avoid the fluctuations brought on by short-term investing, tax rates favor long-term investments.
As noted above, short-term gains are treated as regular income regarding tax rates. Long-term capital gains tax rates are:
- 0%: Single and married people filing separately with less than $40,000 of taxable income pay no capital gains taxes. This also applies to heads of household with $54,100 or less of taxable income and a married couple filing jointly with taxable income of $80,800 or less.
- 15%: Single people and married couples that file separately with taxable income of $40,401 to $445,850 pay capital gains tax rate of 15%. Heads of households with a taxable income of $54,101 to $473,750 or jointly filed married couples with taxable income of $80,801 to $501,600 also pay this tax rate on capital gains for investments held at least 12 months.
- 20%: Any individual or married couple making above the maximum taxable income at the 15% capital gains tax rate is subject to 20% rates for the tax year.
We should note that long-term capital gains on certain collectibles, like precious metals, jewelry, antiques, and coins, are taxed at 28% regardless of income.
Using Capital Gains Tax Planning to Your Benefit
As an investor, it’s only natural that you want to draw the most value out of your assets without exposing yourself to capital gains taxes, if not necessary. Working with financial experts specializing in capital gains tax planning can help you pay fewer taxes and protect your investments.
Some strategies for capital gains tax planning are:
- Think long-term: There are many reasons you may need or want to sell an asset before it qualifies for long-term capital gains tax rates, but you should typically invest for the long-term if you want to avoid paying taxes at regular income rates. And be sure to check that you’ve held a stock for over a year before selling it if you’re unsure.
- Use retirement plans: You can invest your gains into retirement plans without being subject to immediate taxes. Retirement plans like 401(k) and IRAs also enable you to sell investments within your account without facing capital gains taxes.
- Offset Gains with Losses: Not all investments bring gains. You can offset gains with any losses you incur to lower the capital gains taxes you have to pay. In many instances, losses offset gains dollar for dollar. You can also apply losses to future gains.
Summit Wealth Knows How Capital Gains Taxes Work
For nearly 40 years, we’ve helped individuals and families plan their finances, grow their wealth, and navigate capital gains tax complexities. You shouldn’t have to take on capital gains tax planning alone. We’re here to help you make sure your capital gains are taxed at the lowest possible rate and are used to help meet your financial goals. Reach out today to schedule a free consultation and learn more about capital gains tax planning strategies.