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A look at the capital gains tax and how it can affect your investment earnings
Select discusses capital losses and the difference between short- and long-term capital gains tax.
If you bought and sold stocks last year and are preparing your tax return, you may be wondering about how those gains are taxed. This income will fall under the capital gains tax, a special tax that's levied on the sale of an asset — whether it's a home, stocks, bonds, cryptocurrency or mutual fund shares — that has appreciated in value.
When an asset is sold for less money than it was initially purchased for, this is referred to as a capital loss. If you were to sell an asset for a profit, that profit may be subject to a short- or long-term capital gains tax depending on how long you've held the asset, explains Ryan Dennehy, principal at California Financial Advisors.
If the value of your stock appreciates but you don't sell it, this is known as an unrealized gain. When you do sell the stock, however, this is known as a realized gain and you will have to pay either a short- or long-term capital gains tax on it.
For investors, knowing how capital gains tax impacts their tax bill could make a big difference in how much money they earn and save from their investments. Select spoke with Dennehy to learn more about how capital gains tax works and what investors need to know about it.
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What's the difference between short- and long-term capital gains tax?
First of all, there are two types of capital gains taxes: Short-term and long-term. The short-term capital gains rate applies to assets purchased and held for less than one year before they are sold, while assets held for more than one year are subject to the long-term capital gains tax rate.
Short-term capital gains are taxed at the same rate as federal income taxes, which can be up to 37%, while the highest long-term capital gains tax rate is 20% but can be either 0%, 15% or 20% depending on your income and filing status. For this reason, Dennehy typically recommends holding your assets for more than one year to avoid having to pay the higher federal income tax rate.
Long-term capital gains tax rates for 2022:
- 0% rate: Single filers making less than $41,675 and married couples filing jointly but making less than $83,350
- 15% rate: Single filers making more than $41,676 but less than or equal to $445,850 and married couples making more than $83,351 but less than $517,200
- 20% rate: Single filers making more than $459,751 and married couples making more than $517,201
Keep in mind that you'll likely have to pay state taxes on capital gains, regardless of whether they are short-term or long-term, unless you live in Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington or Wyoming, which do not tax capital gains or personal income — depending on the state, you may still need to pay taxes on dividends or interest made from investments. Note that most states tax capital gains at the same rate as state income tax.
However, according to a report by the Center on Budget and Policy Priorities, nine states — Arizona, Arkansas, Hawaii, Montana, New Mexico, North Dakota, South Carolina, Vermont and Wisconsin — offer special tax advantages for long-term capital gains by levying lower tax rates on them than regular income, allowing filers to exclude some portion of capital gains in the calculation of their taxable income or by providing a credit equivalent to a certain percentage of the filer's capital gains. Other states like Idaho, Colorado, Oklahoma and Louisiana, among others, allow tax breaks on capital gains earned by investing in in-state businesses or, in Iowa and Wisconsin, in certain industries like farming.
Beginner investors might want to consider working with a robo-advisor, which uses an algorithm to create a personalized investment portfolio based on your financial goals and will buy and sell assets in a method that will help minimize your taxes. Robo-advisors typically invest in passively managed exchange-traded funds and mutual funds with lower fees. Select ranked Betterment and Wealthfront as the best robo-advisor services.
Those making over certain income limits may also be required to pay a net investment income tax, which considers money made from dividends, capital gains, rentals and royalties as investment income. In general, it's a 3.8% tax that's applied to either your investment income or the amount of money you make above the income threshold.
Income thresholds for Net Investment Income Tax:
- Single filers making more than $200,000
- Married couples filing jointly but making more than $250,000
- Married couples filing separately but making more $125,000
How can capital losses be used to offset your capital gains?
The good news is people can use their capital losses to offset their capital gains. This means if an investor has a stock that's doing poorly and they plan on selling another investment that has appreciated in value, they'll be able to use the losses from their losing investment to reduce the amount of taxes they owe on the gains from their winning stock.
"The IRS allows capital losses that are incurred in the same tax year to offset capital gains. Let's say an investor incurred $10,000 of long-term capital gains over the course of the year, then, at the end of the same year, they decided to sell one of their losing investments that had $8,000 in losses," says Dennehy. "The net effect would be $2,000 of long-term capital gains that they owe taxes on in that same year."
If you're only reporting capital losses in a given year, you can use them to reduce your ordinary income — individuals can deduct up to $3,000 worth of capital losses from their income annually with the option of carrying over their net capital losses from year-to-year, up to $3,000.
Dennehy provides the following example: If you have $10,000 worth of capital losses in one year, you can 'write off' up to $3,000 of your ordinary income that year. The next year, you can use the $7,000 to offset the gains that were accrued that year. If your net gains in the second year are less than $7,000, you can once again 'write off' up to $3,000 of your income.
"This process can continue indefinitely, only ceasing once all net capital losses have been used up to either offset capital gains or offset ordinary income," says Dennehy.
Beware of the Wash-Sale rule
It might be tempting to sell a losing investment and immediately purchase a similar or identical one to help realize a capital loss. Since capital losses are deducted from your ordinary income and can be used to offset your capital gains, some investors might want to do this in the hopes of scoring a tax benefit.
However, Dennehy warns that investors should be aware of the Wash-Sale Rule, which is incurred when an investor sells a security at a loss and then purchases back what he calls a 'substantially identical security' within a period of 30 days.
"In this case, the investor is unable to realize the loss from the sale and their cost basis for the repurchase of the security becomes the same cost basis that they originally had when they first sold," says Dennehy.
Are investments in your retirement account subject to capital gains tax?
Since IRAs are considered to be tax-advantaged retirement accounts, buying or selling investments within these accounts does not incur a capital gains tax, says Dennehy.
Depending on whether the account is a pre-tax or after-tax account, individuals will have to pay income tax on either their upfront contributions or on their distributions in retirement. Traditional IRAs and 401(k)s are considered to be pre-tax retirement accounts since people don't have to pay taxes until they take distributions upon retirement. Roth IRAs and Roth 401(k)s, meanwhile, are considered to be after-tax retirement accounts since individuals have to pay taxes on their upfront contributions, which then allows their investments to grow tax-free over time.
Select ranked Charles Schwab, Fidelity Investments, Vanguard, Betterment and E*TRADE as offering the best IRAs.
How are mutual funds subject to capital gains tax?
Since mutual funds are required to pass down capital gains and dividends to shareholders in the form of a yearly distribution, shareholders are responsible for paying short-term and/or long-term capital gains tax on those distributions, explains Dennehy. Whether an investor is paying short-term or long-term capital gains tax on the yearly distribution they receive depends on the trading activity of the specific mutual fund.
"For example, if an investor purchases shares of a mutual fund in November and then in December, that fund kicks out a large capital gain distribution for the entire year of trading activity," says Dennehy, "that investor is on the hook for paying taxes on capital gains that occurred throughout the entire year, even for trading activity that occurred before they actually purchased the shares of the mutual fund."
Dennehy recommends that investors consider investing in actively traded, tax inefficient mutual funds through their retirement accounts to avoid paying capital gains taxes on yearly distributions.
Tools to help file your taxes
Those who have sold stocks, bonds, exchange-traded funds or mutual funds in the past year simply won't be able to use free services to file their taxes. If you have earnings or losses from investments, you can expect to file a complex tax return, typically through a paid service.
Active stock traders will need to lookout for a 1099-B and 1099-DIV form from their brokerage account. The 1099-B is for investment sales/cost basis and also reflects any wash sale violations in that account. The 1099-DIV is for dividends and capital gain distributions.
Select ranked TurboTax, H&R Block, TaxSlayer and TaxAct as some of the best tax filing software programs based on factors such as cost, customer reviews and user experience.
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Whether you're a seasoned investor or you're still learning how to become one, it's important to know how capital gains tax will influence your tax bill. By holding a security for longer than a year, you can avoid paying the short-term capital gains tax, typically calculated at the federal income tax rate, while the long-term capital gains rate is at most 20%.
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