Understanding Capital Gains Taxes

Capital gains taxes affect your investment returns. Understanding these taxes helps you make smarter decisions about when to sell and where to hold investments. [DEFINITION] Capital Gain: The profit from selling an investment for more than you paid. Capital gains are taxed when realized (when you sell). Unrealized gains (paper profits) are not taxed. ### Short-Term vs Long-Term **Short-term capital gains** (held less than 1 year): - Taxed as ordinary income - Rates: 10% to 37% depending on income - No special tax treatment **Long-term capital gains** (held more than 1 year): - Preferential tax rates - Rates: 0%, 15%, or 20% depending on income - Significant tax savings [KEY] Holding investments for more than one year can save you 10-20% in taxes on your gains. This is one of the simplest tax optimization strategies. ### 2024 Long-Term Capital Gains Rates | Filing Status | 0% Rate | 15% Rate | 20% Rate | |--------------|---------|----------|----------| | Single | Up to $47,025 | $47,026-$518,900 | Over $518,900 | | Married Joint | Up to $94,050 | $94,051-$583,750 | Over $583,750 | [EXAMPLE] You're single with $60,000 income. You sell stock held 2 years for a $10,000 gain. Tax owed: $1,500 (15% long-term rate). If held only 11 months: $2,200 (22% ordinary income rate). Waiting one month saved $700. ### Calculating Your Gain [FORMULA] Capital Gain = Sale Price - Cost Basis - Transaction Costs **Cost basis** includes: - Original purchase price - Commissions paid when buying - Reinvested dividends (for DRIP) - Subsequent purchases at different prices ### Tax-Loss Harvesting [DEFINITION] Tax-Loss Harvesting: Selling investments at a loss to offset gains, reducing tax liability while maintaining market exposure. How it works: 1. Sell investment at a loss 2. Use loss to offset gains (and up to $3,000 of ordinary income) 3. Buy a similar (but not identical) investment to maintain exposure 4. Carry forward unused losses to future years [TIP] The wash-sale rule prohibits buying the "substantially identical" security within 30 days before or after selling at a loss. Buy a similar ETF (sell VTI, buy ITOT) to stay invested while harvesting the loss. ### Tax-Efficient Account Placement **Tax-advantaged accounts (IRA, 401k):** - No capital gains taxes while money stays in account - Hold tax-inefficient investments (bonds, REITs, high-turnover funds) **Taxable accounts:** - Hold tax-efficient investments (index ETFs, buy-and-hold stocks) - Manage for long-term gains - Harvest losses when available ### Minimizing Tax Drag Strategies: 1. **Hold for 1+ years:** Qualify for long-term rates 2. **Use tax-advantaged accounts:** No annual tax on gains 3. **Choose low-turnover funds:** Less distributed capital gains 4. **Avoid frequent trading:** Each sale is a taxable event 5. **Harvest losses:** Offset gains with losses [WARNING] "Don't let the tax tail wag the investment dog." Sometimes selling makes sense even if it triggers taxes. A bad investment with gains is still a bad investment. ### Special Situations **Inherited investments:** - Receive "stepped-up basis" to value at death - Eliminates capital gains on appreciation during owner's lifetime - Major estate planning consideration **Gifting appreciated stock:** - Recipient gets your original basis - Good for charitable giving (donate stock, deduct full value, avoid gains) [EXERCISE] You have a stock with $5,000 gain (held 2 years) and another with $3,000 loss. You're in the 15% long-term bracket. If you sell both, what's your tax? |ANSWER| Net gain = $5,000 - $3,000 = $2,000. Tax at 15% = $300. The loss offset $3,000 of the gain, saving you $450 in taxes ($3,000 × 15%). [SCENARIO] You bought stock at $50, it's now $100, and you believe it will decline. But selling creates a $50 taxable gain. What should you consider? If you genuinely believe it will decline, the tax cost of selling may be less than the investment loss of holding. At 15% long-term rate, your tax is $7.50 per share. If the stock drops from $100 to $80, you've lost $20 per share by holding—far more than the $7.50 tax. Don't let taxes prevent smart investment decisions.