It's easy to get caught up in choosing investments and forget about the tax consequences of your strategies. After all, picking the right stock or mutual fund is difficult enough without worrying about after-tax returns. However, if you truly want the best performance, you have to consider the tax you pay on investments. Here we look into the capital gains tax and how you can adjust your investment strategies to minimize the tax you pay.

Tutorial: Personal Income Tax Guide

The Basics
A capital gain is simply the difference between the purchase and selling price of an asset. In other words, selling price - purchase price = capital gain (if the price of the asset you purchased has decreased, the result would be a capital loss). And, just as tax collectors want a cut of your income (income tax), they aslso want a cut when you see a gain in any of your investments. This cut is the capital gains tax.

For tax purposes, it is important to understand the difference between realized and unrealized gains. A gain is not realized until the security that has appreciated is sold. For example, say you buy some stock in a company and your investment grows steadily at 15% for one year, and at the end of this year you decide to sell your shares. Although your investment has increased since the day you bought the shares, you will not realize any gains until you have sold them. (For more on this subject, see What are unrealized gains and losses?)

As a general rule, you don't pay any tax until you've realized a gain - after all, you need to receive the cash (sell out at least part of your investment) in order to pay any tax.

Holding Periods
For the purposes of determining tax rates on an investment, an investment can be held for one of two time periods: the short term (one year or less) and the long term (more than one year and less than five years). The tax system in the U.S. is set up to benefit the long-term investor. Short-term investments are almost always taxed at a higher rate than long-term investments

Example
Say you bought 100 shares of XYZ stock at $20 per share and sold them at $50 per share, and say you fall into the tax bracket according to which the government taxes your long-term gains at 15%. The table below summarizes how your gains from XYZ stock are affected.

Bought 100 shares @ $20 $2,000
Sold 100 shares @ $50 $5,000
Capital gain $3,000
Capital gain taxed @ 15% $450
Profit after tax $2,550

Uncle Sam is sinking his teeth into $450 of your profits! But had you held the stock for less than one year (made a short-term capital gain), your profit would have been taxed at your ordinary income tax rate which, depending on the state you live in, can be nearly 40%. Note again that you pay the capital gains tax only when you have sold your investment or realized the gain.(For background reading, check out Tax Effects On Capital Gains.)

Compounding

Most people think that the $450 lost to tax is the last of their worries, but that misconception is where the real problem with capital gains begins - unless you are a true buy-and-hold investor. Because of compounding - the phenomenon of reinvested earnings generating more earnings - that $450 could potentially be worth more if you keep it invested. If you buy and sell stocks every few months, you are undermining the potential worth of your earnings: instead of letting them compound, you are giving them away to taxes.

Again, this all comes down to the difference between an unrealized and realized gain. To demonstrate this, let's compare the tax consequences on the returns of a long-term investor and a short-term investor. This long-term investor realizes that year over year he can average a 10% annual return by investing in mutual funds and a couple of blue chip stocks. Our short-term investor isn't that patient; he needs some excitement. He is not a day trader, but he likes to make one trade per year, and he's confident he can average a gain of 12% annually. Here is their overall after-tax performance after 30 years. (Read more about the different types of investing in Buy-And-Hold Investing Vs. Market Timing.)

Long-Term (10%) Short-Term (12%)
Initial Investment $10,000 $10,000
Capital gain after one year 0 $1200
Tax paid @ 20% 0 $240
After-tax value in one year $11,000 $10,960
After-tax value in 30 Years $139,595 $120,140

Because our short-term trader continually gave a good chunk of his money to tax, our long-term investor, who allowed all of his money to continue making money, made nearly $20,000 more - even though he was earning a lower rate of return. Had both of them been earning the same rate of return, the results would be even more staggering. In fact, with a 10% rate of return, the short-term investor would have earned only $80,000 after tax.

Making constant changes in investment holdings, which results in high payments of capital gains tax and commissions), is called churning. Unscrupulous portfolio managers and brokers have been accused of churning, or excessively trading a client's account to increase commissions, even though it diminishes returns.

What To Do?
There are a few ways to avoid capital gains:

  • Long-term investing - If you manage to find great companies and hold them for the long term, you will pay the lowest rate of capital gains tax. Of course, this is easier said than done. Many factors can change over a number of years, and there are many valid reasons why you might want to sell earlier than you anticipated.
  • Retirement plans - There are numerous types of retirement plans available, such as 401(k)s, 403(b)s, Roth IRAs and Traditional IRAs. Details vary with each plan, but in general, the prime benefit is that investments can grow without being subject to capital gains tax. In other words, within a retirement plan, you can buy and sell without losing a cut to Uncle Sam. Additionally, most plans do not require participants to pay tax on the funds until they are withdrawn from the plan. So, not only will your money grow in a tax-free environment, but when you take it out of the plan at retirement you'll likely be in a lower tax bracket.
  • Use capital losses to offset gains - This strategy is not as advisable as the others we just mentioned because your investments have to decrease in value to be able to do this. But if you do experience a loss, you can take advantage of it by decreasing the tax on your gains on other investments. Say you are equally invested in two stocks: one company's stock rises by 10%, and the other company falls by 5%. You can subtract the 5% loss from the 10% gain and thereby reduce the amount on which you pay capital gains. Obviously, in an ideal situation, all your investments would be appreciating, but losses do happen, so it's important to know you can use them to minimize what you may owe in tax. There is, however, a cap on the amount of capital loss you are able to use against your capital gain. (For further reading, see Selling Losing Securities For A Tax Advantage.)

Summary
Capital gains are obviously a good thing, but the tax you have to pay on them is not. The two main ways to reduce the tax you pay are to hold stocks for longer than one year and to allow investments to compound tax free in retirement-savings accounts. The moral of the story is this: by adopting a buy-and-hold mindset and taking advantage of the benefits of retirement plans, you are able to protect your money from Uncle Sam and enjoy the magic of compounding at the same time!

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