- When an investment increases in value, that’s known as a gain.
- When you decide to sell your investment, you are realizing capital gains, which are subject to taxes.
- You can minimize those taxes by holding on to your investment for more than a year.
What’s a capital gain?
Any time you invest in the stock market, your investment has the potential to increase in value. For example, a stock you may purchase for $5 at some point could be worth $10 later on. That increase in value, or profit, once realized is called a capital gain.
Stocks are not the only thing that can have a capital gain — property can too, such as a house, a commercial building, or shares in a small business.
Note: Investments can also decrease in value. When that happens, it’s known as a loss. Realized losses can offset realized gains for tax purposes.
What is the capital gains tax?
While it’s great when your investment increases in value from the time you made the purchase, when it comes time to sell what you own, the capital gains is subject to federal taxes. And you’re obligated to pay those taxes.
An exception is for holdings in tax-sheltered retirement vehicles such as traditional IRAs or 401(k)s. Income gained in these accounts is not subject to taxes prior to retirement. Once in retirement, however, your distributions will be taxed at an ordinary income rate. Another exception is for Roth IRAs and 401(k)s, whose distributions are not subject to taxes when taken in retirement.
So what are the capital gains tax rates?
There are two types of capital gains taxes. One is called the short-term capital gains rate, and the other is called the long-term capital gains rate. Short-term capital gains rates are for investments sold within one year or less of purchase, while long-term capital gains rates are for investments sold after one year of purchase.
It’s important to know there are big differences between long-term and short-term capital gains rates, and that the the tax code rewards you for holding on to your investments for longer than a year.
In a nutshell, short-term capital gains are taxed at the same rate as your current tax bracket. Long-term capital gains are either non-existent, or half of those for your current tax bracket.
Here’s a chart, based on the most recent data from the Internal Revenue Service (IRS), that lays out the difference between short-term and long-term capital gains tax rates for individual taxpayers.
*An additional 3.8% Medicare surtax is currently applied to capital gains for individuals earning more than $200,000 annually.
As you can see, there’s quite a difference between the two rates. Long-term capital gains taxes don’t even kick in until you’re earning $37,651 annually or more. But they apply to all short-term gains for all income brackets.
As a sideline, Congress plans to work on a tax reform package in the coming year, which could include reducing the capital gains tax rate, and eliminating the 3.8% Medicare surtax.