When you sell an investment for more than you bought it, the government wants a cut of the gains. You must pay capital gains taxes on your increased earnings when you realize them. However, the amount of taxes you have to pay on the gains depends on two major factors: how long you have owned the investment and your income.
Now for the good news. You only pay capital gains taxes on the increased value when you sell. So, if you bought an asset for $500, and it appreciates over time to $1,500, you don’t pay taxes on the $1,500 when you sell the asset. Instead, you only pay taxes on the gains — in this case, $1,000.
Table of Contents
- How Capital Gains Work: Long-Term vs. Short-Term
- Tax Advantages to Holding Investments for Longer Periods
- Using Capital Gains Rates to Your Advantage
- What About Investment Losses?
- Tracking Capital Gains (and Losses)
- Special Exclusions to Capital Gains Taxes
- Capital Gains FAQs
- Planning Around Capital Gains Taxes is Only Part of the Picture
How Capital Gains Work: Long-Term vs. Short-Term
The rate at which you pay capital gains taxes is determined by how long you have held the asset, and your income.
If you hold the asset for a year or less, it is considered a short-term investment. You are taxed at your marginal tax rate, meaning the gain is treated as regular income.
If, however, you hold the asset for at least one year and one day, it is considered a long-term investment. When you sell, your gains are taxed at a rate that might differ from your marginal tax rate. Sometimes this works in your favor.
Right now, taxpayers in the lowest two tax brackets don’t pay any federal capital gains taxes when they sell long-term assets.
Those in higher tax brackets will have to pay either 15% or 20% on their capital gains. (Capital gains taxes were previously capped at 15%).
Current Long-Term Capital Gains Tax Rates
|2023 Long-Term Capital|
Gains Tax Rate
|Single Filers||$0 - $44,625||$44,625 - $492,300||Over $492,300|
|$0 - $89,250||$89,2501 - $553,850||Over $553,850|
|$0 - $59,750||$59,750 - $523,050||Over $523,050|
|$0 - $44,625||$40,401-$523,050||Over $523,050|
Tax Advantages to Holding Investments for Longer Periods
As you can see, there are tax advantages to holding investments for longer periods. If you expect your income to increase, holding long-term assets can allow you to take advantage of the lower tax rate on your gains.
Indeed, one of the reasons that many of the wealthiest pay a lower tax rate is that a large chunk of their incomes come from selling long-term investments. You might be in the 32% tax bracket, but if the bulk of your income comes as you sell long-held assets, you are only paying a 15% tax on that income.
Using Capital Gains Rates to Your Advantage
Many wait long enough for their investments to be taxed at long-term capital gains rates before selling. This allows them to realize gains, access funds, and avoid paying short-term tax rates, which are the same as their marginal income tax bracket.
If you’re trying to minimize the taxes, long-term investments are the best choice.
That said, not all buy/sell decisions should be based on the tax impact. That should only be one factor to consider, not the only factor.
Short-term investments and trades can be an excellent option depending on your involvement in your portfolio and your risk preferences. Sometimes you should lock in gains when you have them, rather than risk losing them. It’s better to pay higher taxes on gains than to watch those gains melt away and sell at a loss.
Just be aware that locking in gains on a short-term trade may result in higher taxes.
If you are confused about how your investments will be taxed, I suggest meeting with a financial advisor. They can walk you through the whole process and help you determine which type of investments will be best for you.
How Much Can You Save with Long-Term Capital Gains Tax Rates?
Let’s look at a simple example based on current tax rates. Let’s assume you are Married Filing Jointly, and your taxable income is $250,000. This is right in the middle of the 24% tax bracket.
Now let’s assume you sell some mutual funds for a gain of $10,000.
If this was a short-term capital gain, you would have to pay $2,400 in capital gains taxes.
If this was a long-term capital gain, you would have to pay only $1,500 in capital gains taxes, a savings of $900.
What About Investment Losses?
One way you can offset Capital Gains Taxes is when you lost on another investment. These are Capital Losses, if you will. Let’s see how this works in practice.
Let’s say you have $1,000 worth of stocks in two different companies, Company A and Company B.
Company A’s stock price increases by 20%, but Company B’s stock price decreases by 10%. You decide to sell both at these prices.
So your holdings are now:
- Bought – $1,000
- Sold – $1,200
- Realized Gain – $200
- Bought – $1,000
- Sold – $900
- Realized Loss – $100
The terms, “Realized Gain” and “Realized Loss” indicates that these are no longer paper gains or losses. Once you execute the trade, you have “Realized” the final value. As far as the IRS is concerned, this is what matters.
When it comes time to file your taxes, you subtract any Realized Losses from your Realized Gains.
Keep in mind that all short-term transactions are lumped together, and all long-term transactions are lumped together. You will pay the short-term or long-term capital gains taxes on the gains.
You can write off or deduct up to $3,000 in losses each year against your income if you lose money.
Nobody wants to lose money on an investment. But you can at least use your capital losses to offset some of the gains that would otherwise be taxed.
Note: Be sure to understand the wash-sale rule, which states you can’t deduct losses if you sell an investment at a loss, then repurchase it within 30 days. This is an important tax rule for planning purposes.
Tracking Capital Gains (and Losses)
Not too long ago, it was up to investors to report taxable events to the IRS. However, investment firms and brokerages are now required to track your cost basis (the amount of money you paid for the investment), the duration of time you held the investment, and the final sale price.
All of this is automated on the back end of their software systems. They report the final tally for your account at the end of the calendar year. The IRS logs it on their end, and the brokerage firm sends you an IRS Form 1099 to report your investment gains and losses and whether those gains are short-term or long-term (there is no distinction between short-term and long-term losses).
Most brokerages will also allow you to download a file you can import into your tax software to help make tax filing easier. Once you upload the data, the tax software will process your short-term and long-term gains and offset any losses. Then they determine the appropriate amount of taxes you should pay based on your total tax return (all your income, deductions, credits, and other factors).
The biggest decision you have to make is when to sell to best optimize your gains and losses and, ultimately, your taxes. The rest can be handled automatically.
Specifying Which Shares to Sell
As an investor, you need to pay attention to your overall holdings. More importantly, you need to pay attention to how the cost basis is tracked for your shares.
Brokerage and investment firms will normally track your investments in one of three ways:
- FIFO – First In, First Out
- Average Cost
- Specific ID (spec ID).
FIFO – With the First In, First Out, accounting method, investment firms will always sell the first shares you acquired, regardless of the cost basis. This can be an easy way to track your accounting, but it gives you less overall flexibility in the long run.
Average Cost – The Average Cost of Shares is another simple way to track investments. In some ways, it can be good because it smooths your returns over time. However, like the FIFO method, you lose flexibility in handling your sales.
Specific ID – This accounting method gives you the most flexibility and allows you to “specify” which shares you want to sell. This allows you to sell some shares at long-term capital gains rates, or specify specific shares to sell at a loss if you want to offset some other gains.
Special Exclusions to Capital Gains Taxes
Realize that there are special cases when it comes to capital gains taxes. Two items to consider include:
- Home sale exclusion: If you sell your qualifying primary residence, you are exempt from paying on up to $250,000 in gains ($500,000 in gains if you’re married). This means that if your main home appreciates, and you have primarily lived in the property for at least two years out of the last five, you are eligible for an exemption in need to pay taxes on the gains. Check with IRS to find out how to calculate qualifying and non-qualifying use on the home sale exclusion.
- Collectibles: Collectibles, such as coins or art, are taxed with a maximum capital gains tax rate of 28% unless you have held them for less than a year. If you have held the investments for less than a year, then you will pay your ordinary income tax rate (your marginal income tax rate). Understand that physical gold is taxed as a collectible.
- Lower income tax bracket. Your capital gains rate is zero if you’re in the 10% or 12% tax rate bracket (the standard rate). If your taxable income, after deductions, is lower than $39,475 if you’re single or $78,750 if you’re filing jointly, you’re in this tax bracket.
Capital Gains FAQs
Capital Gains taxes aren’t super-complicated. But it is a good idea to understand the ins and outs to minimize your tax obligations.
Do I Need to Pay Estimated Taxes on Capital Gains?
You may be required to make estimated tax payments if you have a large taxable capital gain. This will depend on the amount of your capital gains, your current income, and other factors.
Will the Capital Gains Rate Remain the Same?
Like all tax rates, the capital gains tax rate is subject to change.
Previously, capital gains tax rates were either 0% or 15%. However, recent tax law changes created three brackets – 0%, 15%, and 20%.
The ultimate long-term tax rate depends on your income.
Even the recent increase still represents tax planning opportunities based on how much of your income is derived from long-term investments. Keep this in mind when planning taxable events, such as selling stocks or other investments subject to capital gains taxes.
Planning Around Capital Gains Taxes is Only Part of the Picture
Investing is the only way to get ahead financially. That said, it doesn’t have to be overly complicated. If you’re new to investing, you might be worried about the taxes you will pay. It’s simpler than you might think. In fact, most tax software programs handle capital gains taxes automatically. Don’t let capital gains taxes scare you away from making some short-term and long-term investments.
Instead, focus on the underlying fundamentals and use the capital gains tax rates to plan your purchases and sales so you can maximize your gains and minimize your tax impact.
If you need any additional tax advice, check out our full Tax Guide.