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 type of security and holding period) can have a big impact on investment results.

Different types of capital gains are taxed at different rates, which needs to be taken into account when making investing decisions.

Taxation and Equities

Capital gains on equities are divided into long-term and short-term gains. In U.S. equities, long- 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 generate 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 in a few months (or even days) at a higher price.

Key Takeaways

  • Long-term capital gains are taxed at a lower rate than short-term gains.
  • Taxation on gains from bonds share some characteristics with gains from stocks, but also have many differences.
  • Interest payments on qualifying municipal bonds are not subject to any federal, state, or local taxes, and are often deemed triple tax-free.

Short-term capital gains (gains on stocks held less for one year or less) are taxed at regular income rates, while most long-term capital gains are taxed at no more than a flat 15% or 20%. 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.

Taxation and Bonds

Taxation on gains from bonds share some characteristics with gains from stocks, but also have 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. If an investor sells before maturity and generates a profit from the bond, there is a capital gain, either short- or long-term, the same as with a stock.

The big difference with bonds is the coupon (interest) payments to bondholders. These seem similar to dividends as 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 taxation. Interest payments on qualifying municipal bonds are not subject to any federal, state, or local taxes, and are often deemed "triple tax-free."

Interest an investor receives from a municipal bond yields dollars they 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.

Mutual Funds

Mutual funds and other funds deserve special consideration regarding taxes. Shares of the fund act the same as stocks and bonds in terms of short- and long-term capital gains: Dividends or interest to the investor is taxed. 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 is 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

Offsetting Gains with Losses

Capital losses also need to be accounted for. For example, if an investor loses $2,000 on a stock and, later in the same year, 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, any remaining losses can be carried over to offset income in future years.

Short-term and long-term gains and losses factor in as well. When offsetting capital gains with losses, investors must offset long-term gains with long-term losses before offsetting short-term gains. 

Taxable or Tax-Free?

The next consideration when thinking about capital gains and investment taxation is whether the account is taxable or tax-free.

For individuals, the best example is an individual retirement account (IRA). For the most part, gains in IRAs are tax-free while they remain in the account. 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.

Before you invest, pay attention to the type of investment you are making, how long you plan to hold it, and its tax implications.

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%. But 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.

The Bottom Line

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