Every four years, when we elect a new president, many eyes are sharply focused on what the new administration will do when it comes to capital gains tax. Diligent investors are watching and wishing they had a capital gains calculator to predict what the impact will be to their tax liability on their tax return.
But when it comes to capital gains tax, it’s not only the federal tax rate you need to understand. State tax rates are also important.
This article will provide the basics about capital gains taxes both federal taxes and state taxes. Well also show how to calculate them and how to minimize your tax liability when selling profitable investments.
What Are Capital Gains?
When you sell an investment, if the market price is higher than the cost basis, or purchase price, of the investment, a capital gain is recognized.
For example, lets assume you purchased 10 shares of XYZ stock at $10 per share:
- The cost basis of that investment is $100 ($10 per share times 10 shares).
- Assuming you sell the stock at $30 per share, youll receive $300 ($30 per share times 10 shares).
- So your capital gain is $200 (the market value of $300 minus the purchase price of $100).
So now, what happens to that $200 of capital gain?
This is where the capital gains tax calculations are important to understand.
What Are Capital Gains Taxes?
Capital gains taxes are taxes you must pay on some profits in your investment portfolio and not just investments like stocks and bonds but other assets too.
Of course, the natural next question is: Which profits? And which other assets?
Capital gains taxes are paid on capital gains from the sale of stocks, bonds, and mutual funds from a diversified portfolio. The sale of tangible assets like cars, boats, and some real estate are also considered capital gains. The sale of your home typically does not qualify.
The more profit your investment portfolio generates, the more taxes you may pay. Similar to income taxes, where your rate depends on your income tax bracket, capital gains tax rates are also progressive in this way.
Capital Gains Calculator
Its time to run our capital gains tax calculator. To find out how that $200 from our previous example will be taxed, we need to consider the term of the investment (long term vs. short term) and capital losses.
Short-Term vs. Long-Term Capital Gains
First, well need to understand if the investment qualified as a short-term or a long-term investment. Depending on the outcome, well know which federal tax rate to use to determine capital gains tax.
Short-term capital gains are taxed at the same rate as ordinary income. The IRS rewards investors who buy and hold by taxing long-term capital gains at a lower rate.
What kind of reward? Well, long-term capital gains can be taxed at 0%, 15%, or 20%, depending on your income bracket, and every year the income tax brackets are subject to change.
So, how long do you have to hold an investment for it to qualify as long-term?
As of April 2021, an investment becomes eligible for the long-term capital gains tax rate once you hold an investment for more than a year.
So, if you bought our example XYZ stock and sold it after owning it for nine months, you would pay the higher short-term capital gains tax rate on any capital gains. But if you held XYZ stock for two years and then sold it, your proceeds would be taxed at the lower long-term capital gains tax rate.
What About Capital Losses?
Of course, your portfolio wont always be in the black. Capital losses can be used to offset capital gains.
The difference between your capital gains and your capital losses is called your net capital gain. If your losses exceed your gains, you can deduct the difference on your tax return, up to $3,000 per year ($1,500 for those married filing separately).
The States Role in Capital Gains Taxes
The majority of your tax liability will be paid to the federal government. But most states want a piece of the action too.
Each state treats capital gains taxes differently. For example, as of April 2021, in New York, if you make $300,000, your income and capital gains tax rate is 6.41%, but in North Dakota, the rate is 2.64%.
Be sure to understand your states capital gains tax brackets and any exclusions that might exist.
How to Minimize Capital Gains Taxes
Ben Franklin once said paying taxes is one thing we can count on in life. So there is no time like the present to get started managing your capital gains tax liability.
Go the Distance
Warren Buffett says that his favorite holding period for stocks is forever.
Hold onto your investments for at least one year in order to qualify for the long-term capital gains tax rate.
When youve done your due diligence to create a comfortable retirement and done everything in your power to ensure your investment is a sound one, the buy-and-hold strategy has many advantages.
The strategy is more risk-averse than trying to capture short-term gains. It is also less time consuming, since youre not constantly watching the market.
Sell High Performers During a Low-Income Year
If possible, wait to sell high-performing investments until you have a year where your income is on the lower side.
This will put you in a lower tax bracket, and your capital gains tax rate will be lower.
Another timing consideration is to wait to sell high performers until you have some losses to offset those gains, which brings us to our next point.
Offset Gains With Losses
As previously mentioned, not all your investments will be winners.
When you sell an investment at a loss, you offset capital gains.
The IRS permits you to:
- Use your capital losses to offset your capital gains
- Offset up to $3,000 of other income with capital losses
- Carry forward capital losses from year to year
For example, lets say you sell stock and record a loss of $10,000 during a year when you have no capital gains. You can subtract $3,000 of that $10,000 from your ordinary income and carry forward the remaining $7,000 to offset gains in future years.
Tax advisers can help manage your investments to minimize tax liability. They are well-versed in selling losses to offset gains.
Use Tax-Advantaged Investment Accounts
When you sell profitable investments inside tax-advantaged investment accounts, like a 401(k) or an IRA, you don’t pay capital gains taxes on profits.
In tax-advantaged accounts, your investment portfolio grows tax-free or tax-deferred until you make a withdrawal. At that point, withdrawals are considered taxable income, and you’ll pay according to your current income tax rate.
Get Started Managing Your Capital Gains Tax Liability
Now you know what capital gains are, how to calculate them, and how to minimize your tax liability.
No one cares about your money more than you do. The last thing you want to do is turn over your hard earned money to the government.
By reading this article, youve taken the first step toward educating yourself and securing a chance to control your financial destiny for retirement without worrying about how youll pay your bills, including the tax bill.
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