What are capital gains and how are they taxed?

Tax rate tables and related info are available at the irs.gov. 

For this video, we will talk about investing in a brokerage account. This is our non-retirement, non-tax advantaged account. When you put money into a brokerage account, you put in post-tax money which is money that has already been taxed. As you build your portfolio, you’ll buy investments like stocks.  Depending on your time horizon, you may choose to keep the investments in your portfolio for a few days, a few weeks or a few years. 

When you sell an investment for more than you paid for it, the result is a capital gain. For example, say you buy Apple stock for $100 and by the time you sell it, Apple stock is $150. The increase in value of $50 is your capital gain. Capital gains are realized when you sell the stock.

Now, while it would be nice to pocket the $50, by selling an asset, you trigger a taxable event. Depending on how long you’ve held the stock will decide the tax rate you’ll pay on your capital gains.

Capital gains are classified as either long-term or short-term and are taxed accordingly.

Long-term capital gains must be held for 1 year and 1 day. Long-term capital gains are taxed using the following tax table. 

I’m sharing both the rates for 2020 and 2021 as reference. The IRS updates the tax rates each year so you can find an updated table at irs.gov.

You’ll note that it’s a very simple table with tax rates of 0%, 15% and 20%. 

For example, in 2020, individual filers won’t pay any capital gains tax if their total taxable income is $40,000 or below. $40,000 includes income from work and income from the sale of assets. However, they’ll pay 15 percent on capital gains if their income is $40,001 to $441,450. Above that income level, the rate jumps to 20 percent.

Short-term on capital gains are held less than a year. Short-term capital gains are taxed just like your ordinary income and depending on your tax bracket, it can mean up to 37%. 

Part of the reason short-term capital gains are taxed at a higher rate is to disincentive speculative trading which can result in market volatility. So if you’ve been buying low and selling high and keeping those assets less than a year, you’ll get taxed accordingly. 

So what can you do to reduce your tax rate on capital gains. 

First is to hold on your investments for at least a year and a day.

Second is to use tax-advantaged accounts like 401k plan, 529 college saving accounts and Roth IRA. Some of these plans allow investments to grow tax-free or tax-deferred. That means you don’t have to pay capital gains tax if you sell investments within these accounts. Roth IRAs and 529s in particular have big tax advantages. Qualified distributions from those are tax-free; in other words, you don’t pay any taxes on investment earnings. With traditional IRAs and 401(k)s, you’ll pay taxes when you take distributions from the accounts in retirement.

Remember with capital gains, the taxes don’t get taken it out so it’s up to you to set aside money to pay what you owe in taxes when you file. 

Links:

For the latest tax rates: https://www.irs.gov/forms-pubs/about-schedule-d-form-1040

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Calculate potential long-term or short-term capital gains taxes using this calculator.