The increased tax liability that investment income generates is a serious consideration, regardless of your tax bracket. However, not all investment income is taxed equally. A firm understanding of the difference between the taxation of long-and short-term capital gains is crucial to ensuring the benefits of your investment portfolio outweigh the costs.

Short-Term vs. Long-Term Capital Gains

The difference between long- and short-term capital gains lies in the length of time the investment is held. Simply put, long-term capital gains are those derived from investments held for more than one year. If you purchase 100 shares of stock for $20 per share and sell them six months later for $25 per share, the $500 in profit is considered short-term capital gains by the IRS.

This distinction is of the utmost importance because short- and long-term capital gains are taxed very differently. In fact, depending on your tax bracket, if you held the 100 shares in the above example for a year or more, you could end up making more money if the stock price continues to increase but still pay less come tax time. In addition, only your net investment income is taxable, meaning if you gain $500 from one investment but lose $500 on another in the same tax year, then your net gain is $0 and you are not required to pay any additional taxes. If you net a loss, you may be able to list it as a tax deduction.

Short-Term Capital Gains Tax Rate

Short-term capital gains are taxed as ordinary income. This means any income you receive from investments held for less than a year must be included in your taxable income for the year. If you have $60,000 in taxable income from salary and $5,000 from short-term investments, your total taxable income is $65,000. If you file as an individual, you would be in the 25% tax bracket and would owe $12,021.25 in income tax for the year (using 2015 tax tables). Of course this amount may be reduced if you qualify for certain tax deductions or credits.

Long-Term Capital Gains Tax Rates

The IRS taxes long-term capital gains at a substantially reduced rate as a means of encouraging individuals and businesses to keep their investments. The difference between the long-term capital gains rate, generally referred to as simply the capital gains rate, and the ordinary income tax rate, which applies to short-term gains, can be as much as 20%.

In 2015, the capital gains rate for those in the 10 and 15% income tax brackets is 0%, meaning those who earn the least are not required to pay any income tax on profits from investments held longer than one year.

For those in the 25 to 35% tax brackets, the capital gains tax is 15%. For the wealthiest citizens who fall into the 39.6% income tax bracket, the capital gains rate is still only 20%.

Assume that, in the example above, your $5,000 in investment income is from long-term investments held longer than a year. In this case, your tax bracket as an individual would still be 25%, but just for the $60,000, on which you would owe $10,793.25. You would only pay 15% on your capital gains, for an additional $750. Instead of a total tax liability of $12,021.25, you would only owe $11,543.25 for the same amount of income. The greater your investment income, the more important this distinction becomes.

A Look at the Math: The Average Joe

Assume you invest $1,000 in the stock market. In two month's time, you could sell those shares for $2,000. However, if you keep them for a whole year, the value jumps to $3,000. Of course, the temptation of doubling your money so quickly is strong, but once you consider the tax implications of both options, the choice may not be so clear.

If you are in the 15% tax bracket, you are required to pay 15% of your $1,000 profit if you sell your shares early, for a total tax liability of $150 in addition to your normal income taxes. If you wait for another 10 months, the $2,000 in profit you earn is yours tax-free.

Assume several years down the road you are making more money and have landed in the 28% tax bracket. You are presented with an identical investment scenario, so you do some quick calculations and determine that taking the short-term profit would cost you $280, while waiting for the long-term rate to take effect creates a tax liability of 15% * $2,000, or $300. Though the total tax is higher for the long-term gain, so is the profit. In the short-term scenario, your tax rate reduces your net gain to $720. In the long-term scenario, even with the slightly higher tax burden, your net profit is still $1,700.

A Look at the Math: A Wealthy Investor

You are a superstar at work and have risen through the ranks so that you earn so much per year Uncle Sam taxes you at the highest possible rate, 39.6%. With all that capital to work with, you are able to invest $10,000 instead of $1,000. In two months, your investment has increased in value to $15,000, but after a full year, it has tripled to $30,000. The tax implications of this kind of investment income can be a serious drain on your resources, so it is even more important to look at the math.

If you take the quick money, you owe $1,980 in taxes in addition to your normal income taxes, reducing your net investment income to $3,020. However, if you hold out until a year passes, your long-term capital gains tax rate of 20% kicks in and your tax liability is reduced to $4,000, or 20% of your $20,000 profit. Again, your total tax is higher, but not by very much. In addition, your net investment gain is only reduced to $16,000, which is still a very healthy profit.

Bear in mind, however, that individuals earning more than $200,000 are also subject to a 3.8% net investment income tax that applies in addition to their short- or long-term capital gains tax rate.

Taxation of Dividends

Dividend income is generated by stocks in your portfolio that pay dividends to shareholders as a means of redistributing company profits and thanking investors for their continued support. Like capital gains, which are generated by an increase in the value of an investment, dividend income is taxed based on the length of time the underlying investment is held.

In general, dividend income is taxed at your ordinary income tax rate. However, if your investment meets certain requirements, your dividends may be considered qualified and are subject to the long-term capital gains rate instead.

The primary requirements for qualified dividends are they be issued by qualified U.S. or foreign corporations and meet a holding period requirement. For a dividend payment to be considered qualified, you must have owned the underlying stock for a minimum of 60 days within the 121-day period beginning 60 days before the ex-dividend date . The ex-dividend date is the date on and after which any new shareholders become ineligible to receive the next dividend. This date is announced by the issuing company when it declares a dividend.

Though it sounds complicated, this regulation is in place to discourage investors who attempt to benefit from dividend payments without maintaining an investment in the issuing company by buying stock right before payment and selling immediately after. Investors can still employ this strategy, but they are required to pay ordinary income tax rates on any dividend income that does not meet the holding period requirement.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.