What You Need To Know About Capital Gains And Taxes

By Wayne Pinsent AAA

A crucial element of investing is managing how much tax you will owe on your gains. Taxes are sometimes overlooked or considered after the fact, but capital gains (depending on the security type and holding period) can have a big impact on investment results. Different types of capital gains are taxed at different rates. This needs to be taken into account when making investing decisions. The following is a quick guide to the different types of capital gains, and what needs to be taken into consideration when making future investment decisions.

TUTORIAL: Personal Income Tax Guide

Taxation and Equities
Capital gains on equities are divided into long-term and short-term gains. In U.S. equities, long term and short term are distinguished by whether the investor has held the stock for more or less than one year. Long-term capital gains are taxed at a lower rate than short-term gains. This is to provide more incentive to invest in the companies that build the economy, rather than trying to make quick profits by speculating on stocks. It brings to mind Warren Buffett's philosophy: to invest in good companies for the long haul. This is in contrast to the notion of buying a stock with the simple hope of selling it to someone else in a few months (or even days) at a higher price.

The application of the rule is not set in stone, though, so this is important to take into account when putting in a sell order. In the U.S. during the George W. Bush presidency, short-term capital gains (gains on stocks held less than one year) were taxed as regular income rates, while long-term capital gains were taxed at no more than a flat 15%. This could have a big impact on profits.

Taxes on capital gains also need to be separated from taxes on dividends from investments. Dividends on a stock are distributions of a company's earnings. These distributions to investors have separate tax laws applied to them, but during the 2000s, qualified dividends have been taxed at no more than a 15% rate. For individuals, common and preferred stock is taxed in the same way with respect to both capital gains and dividends.

Taxation and Bonds
Taxation on gains from bonds share some characteristics with stocks, but also many differences. If an investor buys a bond at par value and holds it to maturity, there will be no capital gain on the transaction. However, if an investor sells before maturity and generates a profit from the bond, then there is a capital gain, either short-term or long-term, the same as with a stock.

The big difference with bonds is the coupon (interest) payments that are paid to bondholders. These seem similar to dividends - both are commonly quoted in yields of the security price - but interest on bonds is taxed very differently depending on the type of bond. Interest payments on corporate bonds are subject to both federal and state taxes. Interest payments on federal bonds are subject to federal taxes, but not state tax.

Municipal bonds are the real winner in the taxation game. Interest payments on qualifying municipal bonds are not subject to any federal, state or local taxes, and are often deemed "triple tax-free." The dollars an investor receives in interest from a municipal bond are the dollars that he or she can put in the bank. This factor must be considered when looking at yields in the markets. The market adjusts these yields so that municipal bonds generally pay lower yields than comparable taxable bonds, but a high-tax-bracket investor may be better served by sticking with tax-exempt issues.(For more on the tax issues surrounding these investments, see Why Retirees Can't Count On Municipal Bonds.)

Taxation and Mutual Funds
Mutual funds and other funds deserve some special considerations. Shares of the fund act the same in terms of short-term and long-term capital gains as stocks and bonds. Dividends or interest that is passed through is taxed, as it would be normally. The main difference is with the fund's internal capital gains. If the fund distributes capital gains from its underlying investments, the investor's gain at the fund manager's whim. A taxable investor would be better off waiting to invest if a mutual fund is about to make a capital gains distribution. (Get other tax tips about these investments at When To Sell A Mutual Fund.)

Offsetting Gains With Losses
Capital gains are not the only concern; capital losses also need to be accounted for.

Example - Offsetting Capital Gains

If an investor makes a bad choice and loses $2,000 on a stock and later in the same year, the investor makes a good investment and earns $3,000, these two transactions will partially offset each other. After netting the two transactions, the investor will only face taxes on $1,000 of the $3,000 gain. If losses exceed gains during the year, the losses can offset up to $3,000 of taxable income. After the total of all gains and $3,000 of income is offset, if losses remain, they can be carried over to offset the next year\'s income.


Short-term and long-term gains and losses factor in here as well. When offsetting capital gains with losses, investors must first offset any long-term gains with long-term losses, before offsetting any short-term gains. (You can learn more about "harvesting" losses at Selling Losing Securities For A Tax Advantage.)


Taxable or Tax-Free?
The next big consideration when thinking about capital gains and investment taxation is whether the account is taxable or tax-free. For individuals, the best example of this is an individual retirement account (IRA). For the most part, IRAs are tax free during their lifetime, so the factors that you need to consider above can be thrown out the window. On an institutional level, the same can be said for pension funds, which can invest tax free.

It may not be wise to actively trade your IRA, but if you see a gain, you can take it without worrying about tax considerations. The main item from above that still applies is with bonds. Tax-free investment accounts should avoid tax-free securities. If you don't have to pay taxes, why not buy the securities throwing off higher yields?

Keep in mind that in most cases your accounts and investments will be taxable. This throws an added wrench into the investing process. An asset expected to return 10% would normally look more attractive than one returning 8%; however, if the 10% return will be taxed at 40%, while the 8% asset will be taxed at 15%, the 8% return will actually leave you with more money in your pocket after all is said and done.

Bottom Line
Keep capital gains effects in mind when making investment decisions, and not just after the fact. Pay attention to the type of investment you are making, how long you plan to hold it and its tax implications before you invest. Managing tax effects by being knowledgeable about how and where your gains are coming from can produce even greater gains in the end.

Find more, read Tax Tips For The Individual Investor.

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