The increased tax liability that investment income generates is a serious consideration, regardless of your tax bracket, and 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 that 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 a short-term capital gain 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 hold the 100 shares in the above example for a year or more and if the stock price continues to increase, you could end up making more money 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, your net gain is zero 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.

Note that regardless of whether you have long-term or short-term capital gains (or both), that income is counted as part of your Adjusted Gross Income (AGI) for the purposes of determining your income tax bracket. However, long-term capital gains are still taxed separately from your ordinary income – you don't pay both capital gains and income taxes on long-term investment income. In fact, as Intuit puts it, "The capital gain, or at least part of it, is always treated as being in the highest bracket that you hit." So if the gain pushes you into a higher bracket than you would have been without it – and it's a long-term gain – the taxes you'd pay on that gain will be at the long-term gains rate, not the ordinary-income rate of that higher bracket. 

Read these examples to learn more about the differences between short-term and long-term capital gains.

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 income is $65,000. Based on the new 2018 tax tables, if you file as an individual, you would be in the 22% tax bracket and would owe $7,599.50 in income tax. 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 to encourage individuals and businesses to hold on to 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 17%.

As of 2018, the capital gains rates no longer correspond directly with income tax brackets. For those at the top of a given bracket, a higher capital gains rate applies. Those filing as single who have taxable income between $9,525 and $38,700 per year, for example, are in the 12% income tax bracket. However, individuals with total income up to $38,600 are in the 0% capital gains bracket, while those who earn just a bit more ($38,601 - $38,700) are in the 15% capital gains bracket. A similar staggering effect is seen for those in the top of the 35% tax bracket.

As just noted, for individuals with up to $38,600 of taxable income, the capital gains rate is 0%. A 15% rate applies to single filers with taxable income between $38,601 and $425,800. The highest capital gains rate (20%) applies only to those with $425,801 or more of taxable income. Below are income and capital gains tax rates for individuals, as well as the different rates that apply to those who are married, filing jointly. (Other rates apply to heads of household and married individuals who file separately.)

2018 Capital Gains Tax Rates

SINGLE

Income

Income Tax

Short Term CG

Long Term CG

$0 to $9,525

10%

10%

0%

$9,526 to $38,600

12%

12%

0%

$38,601 to $38,700

12%

12%

15%

$38,701 to $82,500

22%

22%

15%

$82,501 to $157,500

24%

24%

15%

$157,501 to $200,000

32%

32%

15%

$200,001 to $425,800

35%

35%

15%

$425,801 to $500,000

35%

35%

20%

$500,001 +

37%

37%

20%

 

MARRIED, FILING JOINTLY

Income

Income Tax

Short Term CG

Long Term CG

$0 to $19,050

10%

10%

0%

$19,051 to $77,200

12%

12%

0%

$77,201 to $77,400

12%

12%

15%

$77,401 to $165,000

22%

22%

15%

$165,501 to $315,000

24%

24%

15%

$315,001 to $400,000

32%

32%

15%

$400,001 to $479,000

35%

35%

15%

$479,001 to $600,000

35%

35%

20%

$600,001 +

37%

37%

20%

In the example provided above, assume that your $5,000 in investment income is from long-term investments held for longer than a year. In this case, your tax bracket as an individual would also be 22% for the $65,000 of total income (including your investment income). But because your capital gains are long term, you won't pay the same amount of taxes on them. You would owe 22% on the $60,000 you earned at work, or $6,499.50, but you would only pay 15% on your $5,000 in capital gains, for an additional $750. Instead of a total tax liability of $7,599.50, you would only owe $7,249.50 for the same amount of income. The greater your investment income, the more important this distinction becomes. (For related reading, see: Capital Gains Tax 101.)

An Investment Fairytale

No investment is guaranteed and all investing involves some degree of risk. And, while the quick example above shows that holding your investments for more than a year can result in a lower tax bill, there are often other motivations for selling an investment early. Some investments may be so high-risk that getting out quickly ends up being the smarter move, or you may need liquid capital sooner than expected, or you may decide your money could be put to better use elsewhere. As an investor, it’s always up to you to consider your options and make educated decisions about how to invest and when to sell an asset. Your tax bill should be only one of the factors you consider when making these decisions.

However, for the purposes of the examples below, let’s assume our fictional investors have the inside track on an investment with some guaranteed returns. While the rest of us likely won’t ever be able to see into the stock market’s future, the investors in our two examples know exactly how much their investments will grow and can use that information to make perfectly educated decisions about their tax strategy. The return rates we’ll use certainly aren’t common, or even likely, for most investments, but they do help us illustrate the difference your capital gains tax rate can make.

A Look at the Math: A Young Professional

Eric works at an insurance firm earning $35,000 per year. Wanting to start investing for his future early, Eric invests $1,000 in a stock he knows is poised for big growth. Through the power of his stock market crystal ball, Eric knows that in two month's time he could sell his shares for $2,000. However, if he keeps them for a whole year, the value jumps to $3,000. Of course, the temptation of doubling his money so quickly is strong, but once he considers the tax implications of both options, the choice isn’t so clear.

Since Eric is a single filer in the middle of the 12% income tax bracket, he is required to pay 12% of his $1,000 profit if he sells his shares early, for a total tax liability of $120 in addition to his normal income taxes. If he waits another 10 months, however, the $2,000 in profit he would earn would be his, tax-free.

Assume that some years down the road Eric is making more money and has landed in the 32% income tax bracket (his income is between $157,501 and $200,000). He is presented with an identical investment scenario, so he does some quick calculations and determines that taking the short-term profit would cost him $320, while waiting for the long-term rate to take effect creates a tax liability of 15% x $2,000, or $300. Not only does he see a higher return on investment, the tax bill is lower. In the short-term scenario, Eric’s tax rate reduces his net gain to $680. In the long-term scenario, his net profit is a very healthy $1,700. (For related reading, see: 4 Benefits of Holding Stocks for the Long Term.)

A Look at the Math: A Wealthy Investor

Maria is a surgeon with her own private practice, one of the top specialists in her field. Due to her hard work, she earns so much in 2018 that Uncle Sam taxes her at the highest possible rate, 37%. Since she has taxable income of more than $500,000 per year, she is able to invest $100,000 instead of $1,000. In two months, Maria’s investment will increase in value to $105,000, but after a full year it will grow to $125,000. The tax implications of this kind of investment income could be a serious drain on her returns, so it is even more important to look at the math.

If Maria takes the quick money, she’ll owe $1,850 in taxes, in addition to her normal income taxes, reducing her net investment profit to $3,150. However, if she holds out for a year, her long-term capital gains tax rate of 20% will kick in and her tax liability will be $5,000, or 20% of her $25,000 profit. The long-term option results in a higher total tax bill, but her gains are more than six times what they would have been had she pulled out early.

Of course, this does not take into consideration any additional taxes that Maria may be subject to as a high-income earner – for example, the 3.8% net investment income tax (NIIT), owed by singles with incomes higher than $200,000 ($250,000 for those married filing jointly). If you are in a position similar to Maria’s, speak to a tax professional to ensure you understand your tax liability and strategic options.

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 that they be issued by U.S. or qualified 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 or 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 doesn’t meet the holding period requirement. (For related reading, see: How are capital gains and dividends taxed differently?)

How to Minimize Capital Gains Taxes

Whether you’re investing like Maria or Eric, or somewhere in between, the goal is always to hang on to as much of your investment profit as possible. While the only way to qualify for the 0% capital gains rate is to earn less than $38,600 per year and hold your investments for 12 months or more, there are other strategies you can employ to limit your tax burden.

  • Hang on to Your Home
    If you own your home and are considering a sale, make sure you wait until you’ve lived in it for at least 24 out of the past 60 months. If you own and occupy your primary residence for at least two years, you qualify for a Section 121 exclusion, meaning you don’t pay capital gains taxes on up to $250,000 of gain if you’re single, or $500,000 if you’re married filing jointly.

  • Learn About the 1031 Exchange
    If you own real estate as an investment and would like to sell, consider speaking with a tax professional about the 1031 exchange process. There are rules and regulations to keep in mind, but a successful 1031 exchange allows you to sell property and reinvest the proceeds into new real estate without paying capital gains or depreciation recapture taxes.

  • Carry Over Last Year’s Losses
    If your net investment losses exceeded the maximum allowable deduction in the last tax year ($3,000 in 2017 and 2018), remember to carry over the excess to your current tax return to offset this year’s gains.

  • Invest in a Tax-Advantaged Account
    Investing within a qualified retirement account – like a 401(k) or an IRA – can allow you to reap the rewards of successful investing without paying capital gains when you sell appreciated assets. If you invest in a Roth account, you pay income taxes on your contributions in the year you earn them, but will be able to withdraw your earnings tax-free after retirement, avoiding capital gains taxes completely. The 529 education savings plan offers similar tax advantages.

  • Harvest Your Losses
    If you have underperforming investments you’d like to let go of, consider selling them before the end of the tax year and using those losses to offset your gains. For those who need help, many managed investment services include tax strategy and loss harvesting guidance.

The Bottom Line

It pays to consider the tax implications of any income generated by your investments so you can take advantage of lower rates. Consult with a financial or tax advisor if you have questions about the most advantageous course of action for your individual situation.

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