So, you’ve hit it big with your investments or any successful asset trade. Congratulations on your impressive win! But hold on tight to those profits because the IRS isn’t about to let you off the hook. They want a slice of your gains, too. If you’ve made a profit on an investment in a taxable account, you’ve earned what’s called a Capital Gain, and you’ll need to pay Capital Gains Tax on it.
Now, these taxes can have a significant impact on your investment returns, and let’s face it, the rules and regulations can be a bit of a labyrinth. But fret not! We’ve got you covered. We’ve done all the legwork and research for you. So, sit back and relax as we unravel the basics of capital gains taxes, how they actually work, the different rates involved, and even some exceptions to keep in mind.
Whether you’re an experienced investor or just dipping your toes in the investment world, grasping the concept of capital gains tax is absolutely crucial for optimizing your returns. So, let’s dive right in and demystify this topic together!
What Is the Capital Gains Tax?
Capital Gains Tax is a tax that investors like you have to pay on the profits made from selling various assets such as stocks, real estate, businesses, and other investments held in non-tax-advantaged accounts.
How Does it Work?
So, how does the taxation of capital gains work?
Well, it depends on factors such as your filing status, taxable income, and the duration for which you held the asset before selling it. The key thing to remember is that you only owe taxes when you actually sell the asset, not while you’re holding onto it. That’s when your gains become “realized gains.” On the other hand, if you still possess the asset and haven’t sold it yet, those gains are referred to as “unrealized gains,” and you won’t have to pay capital gains taxes on them.
You might be wondering when a capital gains tax is levied.
The answer is simple: when you sell an asset for a higher price than what you originally paid for it. However, it’s worth noting that most possessions tend to depreciate over time, so the sale of everyday items typically won’t be considered capital gains. Nevertheless, you must remember that any purchase you make, which you later resell for a profit, can be subject to capital gains taxes.
Let’s take a few examples to clarify this further. Suppose you decide to sell that beautiful piece of artwork, that vintage car you restored with love, a luxurious boat, or even some exquisite jewelry for more money than what you initially spent on them- your gains will be classified as capital gains, and you’ll be responsible for paying the associated taxes. Additionally, if you’ve dabbled in the world of cryptocurrency and sold some bitcoin at a profit, you’ll also find yourself liable for capital gains taxes.
Understanding capital gains tax is crucial for any investor. By familiarizing yourself with the ins and outs of this tax, you can make more informed decisions about when to buy, sell, or hold onto your assets.
Capital Gains Tax: Short-Term vs. Long-Term
When it comes to capital gains taxes, understanding the difference between short-term and long-term can save you a significant amount of money. It all boils down to the length of time you hold an asset. Let’s dive into the details and discover how these two categories affect your tax obligations.
- Short-term capital gains tax applies to profits made from selling an asset that you’ve owned for less than a year. The tax rate for short-term capital gains aligns with your ordinary income tax rate, similar to what you would pay on your wages from a job. These rates fall within specific brackets, ranging from 10% to 37%. So, if you sell an asset within a year, you can expect to pay taxes based on these brackets.
- Long-term capital gains tax applies to assets held for more than a year. The tax rates for long-term capital gains are generally lower, standing at 0%, 15%, or 20% for most assets held beyond a year. Holding onto an asset for a longer period can positively impact your tax liabilities.
Let’s break it down with an example: Suppose you buy $5,000 worth of stock in May and sell it in December of the same year for $5,500, resulting in a short-term capital gain of $500. If you fall into the 22 percent tax bracket, the IRS will require you to pay $110 from your $500 capital gains. This means your net gain after taxes would amount to $390.
Now, let’s explore an alternative scenario if you hold onto the same stock until the following December and sell it for $5,700, resulting in a long-term capital gain of $700. Assuming your total income places you in the 15 percent bracket for long-term capital gains, your tax payment would be $105 instead of $110. As a result, your net profit would increase to $595.
By strategically considering the timeframes for holding assets, you can potentially reduce your tax burden and maximize your overall profits.
How is capital gains tax calculated? (4 Steps)
1. Separate your short-term and long-term capital gains (because they are taxed in different ways.)
2. Total your short-term capital gains and losses, adding and subtracting to get your net gain or loss.
3. Total your long-term capital gains and losses, adding and subtracing to get your net gain or loss.
4. Use tax preparation software – or go to your tax preparer – to determine your tax liability.
Capital Gains Tax Rates for 2022 and 2023
Although the Tax Cuts and Jobs Act of 2017 maintained the same capital gains tax rates, it’s important to note that the income thresholds for each bracket are adjusted annually to keep pace with the growing earnings of hardworking individuals. Let’s delve into the specifics of the capital gains rates for the 2022 and 2023 tax years.
|
2022 Long-Term Capital Gains Tax Brackets (taxes due April 2023) |
||||
|---|---|---|---|---|
|
Tax Rate |
Single |
Married, joint filing |
Married, separate filing |
Head of household |
|
0% |
$0 – $41,675 |
$0 – $83,350 |
$0 – $41,675 |
$0-$55,800 |
|
15% |
$41,676 – $459,750 |
$83,351 – $517,200 |
$41,676 – $258,600 |
$55,801 – $488,500 |
|
20% |
$459,751 or more |
$517,201 or more |
$258,601 or more |
$488,501 or more |
|
2023 Long-Term Capital Gains Tax Brackets (taxes due April 2024) |
||||
|---|---|---|---|---|
|
Tax Rate |
Single |
Married, joint filing |
Married, separate filing |
Head of household |
|
0% |
$0 – $44,635 |
$0 – $89,250 |
$0 – $44,625 |
$0 – $59,750 |
|
15% |
$44,626 – $492,300 |
$89,251 – $553,850 |
$44,626 – $276,900 |
$59,751 – $523,050 |
|
20% |
$492,301 or more |
$553,851 or more |
$276,901 or more |
$523,051 or more |
Remember: When it comes to short-term capital gains, they are subject to taxation as ordinary income based on the federal income tax brackets.
Capital Gains Tax Rules and Considerations
We’ll delve into notable exceptions to better navigate this complex landscape.
1. Collectible Assets: Unveiling the 28% Rule
While most assets are subject to standard capital gains tax rates, there are exceptions worth noting. “Collectible assets,” such as coins, precious metals, antiques, and fine art, can be taxed at a maximum rate of 28% for long-term gains. Short-term gains on collectible assets are taxed at the ordinary income tax rate.
2. The Net Investment Income Tax: Additional Considerations
Some investors may be subject to the net investment income tax, which adds an extra 3.8% to either their net investment income or their modified adjusted gross income.
The threshold amounts that trigger this tax are as follows:
- Single or head of household: $200,000
- Married, filing jointly: $250,000
- Married, filing separately: $125,000
- Qualifying widow(er) with dependent child: $250,000
Smart Strategies to Minimize Capital Gains Taxes
- Monitor Your Holding Periods: Long-term gains generally enjoy more favorable tax rates than short-term gains.
- Leverage Tax-Advantaged Accounts: Consider utilizing tax-advantaged accounts such as 401(k) plans, individual retirement accounts (IRAs), and 529 college savings accounts. These accounts offer tax-free or tax-deferred growth. When you eventually withdraw funds for qualified expenses like retirement or education, you won’t owe federal income taxes on the earnings or initial investment.
- Rebalance with Dividends: Instead of reinvesting dividends into the same investment, strategically rebalance by allocating those funds to underperforming investments.
- Keep Records of Losses: Capital losses can offset gains and reduce your taxable income by up to $3,000 annually.
- Avoid Buying Back Losing Investments: The IRS penalizes “wash sales,” where an investor sells an asset for tax benefits and repurchases an identical investment within 30 days.
TL;DR
Dealing with capital gains can seem daunting, especially if you procrastinate in grasping how they can impact your finances when it’s time to file taxes. However, by determining the duration of asset ownership, potential purchase, and sales prices, alongside your tax filing status and income bracket, you can easily estimate the amount you might owe in taxes.
