One of the realities of life is that you are expected to pay taxes on your income. This includes investment income. When you make money off your investment portfolio, it becomes necessary to report it on your tax return. However, the type of investment gain you have determines the way you are taxed on the income.
What are Capital Gains?
Capital gains represent that amount of money you have received due to the appreciation of an asset. If you buy 100 shares of stock at $50 apiece, you spent $5,000. Over the course of 10 years, let’s say that the stock price increases to $65 a share. You decide to sell your 100 shares for $6,500. You are richer now, even though you did nothing beyond invest money in a stock.
Because the stock is worth more now than it was before, your sale results in a capital gain of $1,500. It is this $1,500 investment return that you are taxed on come April.
It is important to realize that capital gains are different from the income that you receive as a result of other investments. Interest income, such as what you receive from keeping money in a savings account or CD, and dividend income, received in the form of payouts from certain companies that you invest in, are taxed differently than capital gains.
Long-Term Capital Gains vs. Short-Term Capital Gains
When calculating capital gains taxes, it’s important to understand the difference between long-term gains and short-term gains. A long-term gain is often taxed at a lower rate than a short-term gain. The top rate for long-term capital gains is 20%. If you fall in an income bracket that requires you to pay the top capital gains tax rate, you are likely paying a higher rate on your regular income.
Short-term capital gains, though, are taxed at your regular rate. So, if you are in the 39.5% tax bracket, and your $1,500 gain is a long-term gain, you only have to pay 20% on it. However, if your $1,500 is a short-term gain, then the money counts toward your regular income, and you pay a higher rate on it.
A long-term capital gain is anything that you have held for more than a year. So, if you want a gain to count as “long-term,” you need to make sure to hold onto it for at least a year and a day. If the investment is held for less than that time period, it is considered short-term, and taxed at your regular income rate.
The law is structured this way to encourage long-term investments. This adds an undercurrent of stability to the market. A lot of short-term trading can lead to higher volatility, so encouraging long-term investments can be one way to reduce market volatility over time (although there is no way to completely get rid of it — especially in the short-term).
Consider your investment strategy, and then look at how you can improve your tax efficiency. If you want to pay less tax on your investment gains, adopting a long-term strategy might be one way to earn more money over time with greater tax efficiency.