Understanding Long-Term vs. Short-Term Capital Gains Tax
October 14, 2020
By Rahul Iyer
When it comes to tax, not all capital gains are treated equally. Making a substantial profit on your financial securities is excellent, but you'll take to pay tax, and the tax you pay will depend on how long you've held the asset.
Short-Term Capital Gains Tax
Short-term capital gains tax is the tax you pay on profits from the sale of assets that you have held for less than one year. Short-term capital gains have no special tax status and are taxed at your ordinary-income rate. This can mean that you are pushed into a higher tax bracket. For example, let's say you fill out your IRS tax filing as a single. You gain $84,000 in salary, which puts you in the 22% federal tax bracket. However, you then generate $4000 in short-term capital gains. This then pushes your income up to $88,000 and into the 24% tax bracket.
Long-Term Capital Gains Tax
An asset will fall into the category of long term capital gains if you hold it for more than a year before selling it. You should start counting one year (365 days) from the day after purchasing the asset if you plan to benefit from the special tax rate associated with long-term capital gains. In most cases, you can take advantage of long-term capital gains tax status if you sell your assets after one year, but there are a few notable exceptions. For example, some exceptions exist for commodity futures and real estate.
Long-term capital gains are taxed at either 0%, 15%, or 20%, depending on your income and how you file your taxes. For example, if you are a Single and your income is up to $39,375 (2019), you will pay 0% on your capital gains. However, if your income is between $39,376 and $434,550, you will pay 15%. This jumps up to 20% for Singles earning over $434,550.
With IRAs and other retirement accounts like 401(k)s, you get certain tax benefits. One of these benefits is that you can defer paying taxes until you withdraw money from the account. However, there is a drawback. All contributions that you withdraw from these tax-deferred accounts will be treated as regular income and taxed as such. This is one reason why some financial advisors discourage people from squirreling away all of their money into their 401(k) plans.
Sometimes, our investments don't go the way we expect, and we end up losing money. When this happens, you can use your losses to reduce your taxes by calculating your "net" capital loss or gain. You can also carry losses forward to subsequent years if you hit the limit for your current filing year.
It sounds pretty straightforward so far, right? Well, some exemptions make capital gains tax a little more complex.
Collectibles such as art, comic books, antiques, jewelry, and precious metals are taxed at 28%, regardless of your income.
Real estate - If you sell your principal residence, then $250,000 of profits will be excluded from your taxable income as long as you have owned and lived in the property for two or more years.
This list isn't exhaustive but is meant to highlight the most notable exemptions.