What’s the Deal With Capital Gains on Stock?

Daniel Penzing
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What Are Capital Gains on Stock?

A capital gain is the profit you earn on an investment. Not all capital gains are the same … there are two main types: short term and long term.

Short-term capital gains occur when the asset you’ve invested in loses value. This may seem odd at first, but this also means that short-term capital gains are taxed at your regular income tax rate. These gains benefit from a 0 percent tax rate when held for less than a year, but then get taxed as ordinary income when held for more than twelve months.

Conversely, long-term capital gains are taxed much more favorably; as such, there is a 15 percent tax rate on long-term capital gains. It should be noted that tax treatment on long-term capital gains varies between federal and state tax jurisdictions. To be considered a long-term capital gain, the asset must be held for more than one year.

Capital gains can be earned with several financial instruments, including stocks, bonds, and real estate. In some cases, it is not prudent to sell an asset when its price is at its peak. It is often prudent to take advantage of short-term gains upfront and wait on long-term gains until the asset has achieved a higher price.

Capital Gains Distributions on Mutual Funds and Exchange-Traded Funds (ETFs)

A mutual fund or ETF might pay capital gains distributions each year. The fund's board of directors decides whether to pass on any of its capital gains to its shareholders. Shareholders don't have to pay taxes on the distributions until they file their tax returns.

Capital gains distributions aren't subject to federal income tax withholding. At year's end, your fund should send you a Form 1099-DIV for your records.

If you are investing in mutual funds or ETFs for a long period of time and expect to be in the same income tax bracket when you sell them as when you bought them, it might not make sense to worry about capital gains distributions. You will benefit if your mutual fund or ETF has capital losses. If the fund has gains, the capital gains distributions will push you into a higher tax bracket. The additional taxes will lower the after-tax return on your investment.

Losses can be used to offset capital gains from any source. This includes mutual fund or ETF capital gains distributions and capital gains from outside investments. You report the investment losses and the capital gains distributions on Form 1040 Schedule D, along with your other capital gains and losses. Any net long-term capital losses (net of capital gains distributions) are subject to an annual limitation. This limitation works to curb the potential tax benefit of long-term capital losses.

How Long to Hold Stock for Capital Gains

To some, it might seem silly that a tax year can have an effect on the length of time you should hold your investments. Individuals and investors will often hold their investments for long periods of time, sometimes for decades. This long-term approach is in part due to stock market volatility. When markets are trending in a downward trend, investors often hold on for dear life and wait for the market to rebound in an upwards trend. Holding on even when the market is doing well can never hurt, as it’ll help you retain your income and its corresponding tax benefits. But with the changes to the tax laws and more investors becoming aware of the 3, 5 and 10 year capital gains requirements, many are adopting a shorter holding period to minimize their capital gains and avoid buyer’s remorse.

Capital Gains & Losses

The way your capital gains and losses are treated is directly impacted by your investment holding period. Capital assets that you hold for more than one year are subject to long-term capital gains (or losses). The current tax rate for long term capital gains is 15%. Capital assets that you hold for a year or less are subject to short-term capital gains and the current tax rate for short term capital gains is 35%.

How Much Is the Capital Gains Tax on Stocks?

The capital gains tax rate for stocks is slim.

You’ve probably heard the term “capital gains” when you hear discussions about the stock market, but you may not understand what it is and how it applies to your investing strategy.

Basically, capital gains refer to income that you earn on an asset that you own.

If you own a stock that has increased in price, it’s called a capital gain.

A capital gain is classified as either short term or long term.

Short-term capital gains are taxed as regular income, while long-term capital gains are taxed at a lower rate as part of your income tax.

How to Avoid Capital Gains Tax on Stocks

Imagine that you have a property that you have owned for many years. You paid a certain amount for the property, and now the value is higher than you purchased it for. However, you have not sold the property yet, so the difference between your original purchase price and what the property is worth is known as capital gains.

If the property is sold for a profit, then any capital gains due are counted as income and therefore have to be paid taxes. This is the reason why you will usually pay taxes on your stock trading operations via the capital gains route. Let’s take a closer look at how to avoid capital gains tax on stock.

Hold appreciating assets in a tax-sheltered retirement plan.

For starters, there is the tax shield aspect. You won’t pay taxes on your capital gains until you withdraw, meaning the value of the investment is growing tax-free. It also means that the capital gains will be taxed upon withdrawal, but by then it could be anywhere from 25% to 35% less than if you had invested via a taxable account.

Secondly, you may be able to deduct your losses in a retirement account. If you have incurred an investment loss in a taxable account and have covered it from your income, you can’t deduct the loss from your ordinary income tax. However, with a traditional IRA or a 401(k), such a loss will be considered prior to figuring out the taxable income.

Offset capital gains with capital losses.

Don't sell your investments.

I have good news and bad news.

The good news is that dividends on stocks are not taxed until you sell.

The bad news is that capital gains are not a perk. Instead of being taxed at 15-20%, as most people think, they are taxed at 30-35%.

So what's the lesson here?

Hold on to those stocks for as long as possible.

Capital Gains Help You Build Wealth Over Time

Capital gains are one of those things in investing that people know exist but do not often fully grasp. That said, if you’re familiar with capital gains, you may still have a bit of confusion. Capital gains are often confused with capital losses, and even experienced investors may not understand the intricacies of the rules surrounding them.

Let’s explore capital gains quickly. Definitionally, capital gains are realized when you have a profit on an investment. You mark the difference you made on paper, and this is your capital gain. With capital gains, you generally need to hold your investment for some time. For example, if you hold a stock for a year and sell it for a profit, you pay long-term capital gains taxes. Capital losses, on the other hand, are generally realized when you have an investment that declines in value. A capital loss is the loss you’ve experienced due to depreciation in value. With capital losses, you are able to deduct them from capital gains when calculating your taxes. You do not need to hold an investment long-term to realize a capital loss. Instead, a capital loss arises whenever you’ve made an investment that has declined in value.