As an investor, it is possible to earn thousands of dollars in capital gains over the long term. These capital gains, however, do carry important tax ramifications that affect your bottom line. Through smart tax planning, it is possible to avoid paying capital gains taxes. To do so, you must familiarize yourself with investment holding periods and basic tax law.
Tax ramifications are applicable to realized capital gains. You realize capital gains when you sell stock at a profit. For tax purposes, capital gains are categorized as either short-term or long-term capital gains. Short-term capital gains are taxed at ordinary income rates of 10, 15, 25, 28, 33 and 35 percent. Long-term capital gains, however, may be tax-free or taxed at maximum 15 percent rates.
To qualify for long-term capital gains tax treatment, you must hold shares of stock for more than one year. After one year, you may be able to sell shares and reinvest cash into the stock market with no tax consequences.
United States tax law is progressive, where the wealthiest individuals pay the highest tax rates. For your tax-free long-term capital gains, you must report less than $35,350 in taxable income as a single or married, filing separate taxpayer. This income limit increases to $70,700 and $47,350 for married filing jointly and head of household, respectively.
Calculating realized capital gains begins with knowledge of your basis for trading stock. Basis includes brokerage commissions within the costs of acquiring stock and the cash received from selling it off. For example, your brokerage may charge $7 per trade in commissions. The cost basis for buying 20 shares of Stock Z at $50 would then be $1,007 (20 shares x $50 = $1,000 + $7 = $1,007). After two years, you may sell Stock Z for $75 per share. Your basis on the sale would then be $1,493 (20 shares x $75 = $1,500 - $7 = $1,493). At that point, your realized long-term capital gains would be $486. Again, you would pay no taxes on these profits if your taxable income works out to be less than $35,350 as a single filer.
Retirement accounts allow you to reinvest money into the stock market on a tax-deferred basis. Traditional Individual Retirement Account (IRA) and 401k accounts are funded with deductible contributions, and investment gains are not taxed until money is withdrawn from your account. At that point, your entire Traditional IRA and 401k balances are taxed as ordinary income. Roth IRAs are funded with after-tax money and also provide tax-deferral. Roth IRA withdrawals are tax-free at retirement. To avoid a 10 percent tax penalty, you should not take money out of your retirement accounts until age 59 1/2.
Your ultimate goal is to make the most money for the least amount of risk. Creating wealth does not always translate into paying the least amount of taxes. For example, you should not continue to hold onto a losing stock over the long term simply to avoid paying capital gains taxes.
- Internal Revenue Service: Topic 409 Capital Gains and Losses
- Internal Revenue Service: 10 Facts About Capital Gains and Losses
- Internal Revenue Sevice: Retirement Plans FAQs Regarding IRAs
- Internal Revenue Service. "Topic No. 409: Capital Gains and Losses." Accessed Feb. 25, 2020.
- Internal Revenue Service. "Publication 544 (2018): Sales and Other Dispositions of Assets," Page 20. Accessed Feb. 25, 2020.
- Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2019." Accessed Feb. 25, 2020.
- Tax Policy Center. "Briefing Book: How are Capital Gains Taxed?" Accessed Feb. 25, 2020.
- Internal Revenue Service. "Topic No. 701: Sale of Your Home." Accessed Feb. 25, 2020.
- Internal Revenue Service. "Find out If Net Investment Income Tax Applies to You." Accessed Feb. 25, 2020.
- Internal Revenue Service. "Rev. Proc. 2018-57," Page 11. Accessed Feb. 25, 2020.
- Internal Revenue Service. "Retirement Topics - Contributions." Accessed Feb. 25, 2020.
- Internal Revenue Service. "Publication 590-B: Distributions from Individual Retirement Arrangements (IRAs)," Page 13. Accessed Feb. 25, 2020.
- Internal Revenue Service. "Publication 590-B: Distributions from Individual Retirement Arrangements (IRAs)," Pages 28-29. Accessed Feb. 25, 2020.
- Internal Revenue Service. "Publication 550: Investment Income and Expenses," Pages 43-44. Accessed Feb. 25, 2020.
Kofi Bofah has been writing Internet content since 2010, with articles appearing on various websites. He is the founder of ONYX INVESTMENTS, which is based out of Chicago. Bofah enjoys writing about business, finance, travel, transportation, sports and entertainment. He holds a Bachelor of Science in Business Management from the University of North Carolina at Chapel Hill.