Paying the capital gains tax is the bitter cherry on the sundae. Congratulations, you had a good year of investing … and now you’re going to pay for it!
Still, there are some silver linings that taxpayers should know about, such as the fact that you might not have to pay as much as you thought.
But first, let’s look at the basics of the capital gains tax. As with anything with the IRS Code, the rules can get confusing and downright nonsensical, so it’s best to understand the basics as best as possible — that way, you’ll be better equipped to figure out how to navigate some tax savings.
The Basics of the Capital Gains Tax
For the most part, there are two types of income that are taxable:
- Ordinary income, which includes wages, commissions, tips, bonuses, interest, dividends, pensions, IRA distributions and alimony.
- Long-term capital gain, which is the income generated from the sale of a capital asset like a stock, bond, mutual fund or real estate.
The calculation for a long-term capital gain is the difference between the proceeds you get from the sale (called the amount realized) and the cost of capital asset (known as the cost basis). The cost basis doesn’t just include how much you paid for the asset, but also things such as fees and commissions.
We’ll look at an easy example that ignores commissions for now.
Let’s say you have a regular brokerage account (so, not a tax-advantaged IRA or other account) and you purchased 100 shares of Facebook Inc (FB) stock at $50 for a total of $5,000. This is your cost basis. After a year, the stock goes up to $105, and you sell your shares for a total of $10,500. That’s your amount realized. Your total capital gain is $5,500 — $10,500 in amount realized minus $5,000 in cost basis.
So, how much do you pay in capital gains taxes?
Well, remember — if you sell Facebook in less than a year, that’s a short-term capital gain, which is taxed the same as your ordinary income. So, your tax rate would be anywhere between 10% and 39.6%.
However, the situation becomes much more favorable if you’ve held on to Facebook for more than a year. Here’s a look at what your long-term capital gains tax rate would be, depending on your current tax bracket for ordinary income:
|Current Tax Bracket||Capital Gains Tax Rate|
|10% – 15%||0%|
|25% – 35%||15%|
Note: The 0% rate may not apply to children under age 19 or students under age 24 because of the so-called Kiddie Tax, which provides for certain income to be taxed at parents’ rates.
A few other factors to consider:
- There is a 3.8% Medicare tax on unearned income for high-income taxpayers (modified adjusted gross income of $200,000 for those who are single, $250,000 for those who file joint returns and $125,000 for those who file separate returns).
- There may be a state tax, which is generally at the same rate as federal ordinary income.
As far as reporting goes: You report capital gains transactions on Form 8949, then summarize them on Schedule D.
And to estimate your capital gains tax, you can check out the following online calculator.
Strategies for the Capital Gains Tax
Of course, you can maneuver around the capital gains tax in ways to either avoid it, lessen your tax burden or even make the IRS work for you.
A few strategies to consider:
Set Up a Tax-Advantaged Account: Tax-advantaged accounts include things such as individual retirement accounts, Roth IRAs and 401ks. In the case of 401ks and regular IRAs, you use pre-tax money to fund the account, and are instead taxed on that money when you take distributions from the account (which you can do penalty-free when you reach 59 ½. In the case of a Roth IRA, you pay with income that has already been taxed — but then you aren’t taxed when you take distributions.
Short-Term Capital Gains: Try to avoid taking these, as they involve higher tax rates (see above). Obviously, this strategy doesn’t make sense on things like swing trades and options trades. But if you make well more than what you expected on what you thought would be a longer-term trade anyway, consider waiting long enough to cash out of the position and banking it as a long-term gain for the lower rates.
Long-Term Capital Losses: If you have a healthy long-term gains to lock in, but also healthy long-term losses, it can make sense to recognize both.
In any given year, you can deduct up to $3,000 of capital losses from other types of income. So, say you only made one transaction in a given year, and that was for a transaction that netted a $3,000 loss, you could deduct $3,000 from other income you earned that year. However, capital losses can be used against capital gains to help lessen your tax burden — both in the current year and in future years.
Let’s continue using the Facebook example from above. You sold out of your Facebook position to realize a capital gain of $5,500. However, you also decided to take a bath on a Twitter Inc (TWTR) position that you’ve held for more than a year and end up recording a $20,000 loss. Well, $5,500 of that can be used to net out the $5,500 gain in FB. An additional $3,000 can be used against other income. And you have $11,150 that you can use in future tax years. (Note: You can’t carry it backward.) You can use that against future capital gains in the same way you did against the FB position, but if you don’t have capital gains in a given year, you can still deduct $3,000 of it a year against other income.
Keep tax rates in mind when considering taking things as short-term or long-term gains and losses. If you have a significant short-term loss, as well as significant short-term gain that you could take, do so. It would be better to reduce or cancel out your tax obligation completely that way than to wait for the short-term gain to become a long-term gain just for the lower tax rate.
Example: You have a short-term gain of $5,000 and a short-term loss of $5,000. Using the loss to cancel out the gain would save up to $1,980 in taxes (39.6% bracket). However, if you wait for both to become long-term, that same cancellation would only save up to $1,000 in taxes (20% long-term capital gains tax rate).
Mutual Funds and the Capital Gains Tax
There’s an important “gotcha” you should know about if you’re invested in mutual funds through a non-tax-advantaged account.
You see, at the end of the year, the mutual fund might make a large distribution of capital gains. That’s good, because it’s helping your returns — but it also delivers a nasty surprise in that you will owe taxes on this regardless of whether you reinvest the money into the fund.
This can even happen in down years if the mutual fund starts to heavily sell winners that were purchased years ago. And in some cases, the distributions might be for short-term gains, which are of course taxed at higher rates.
There’s nothing you can do to avoid this once it happens, but you can look for warning signs in mutual funds before buying. Watch out for high turnover (more than 50%) in the portfolio or large redemptions from shareholders (perhaps more than 10% of the portfolio).
Mutual fund companies will disclose the likelihood of capital gains distributions during November and December.
Tom Taulli is an Enrolled Agent (the highest designation for the IRS) and the founder of BizDeductor, which offers services and apps to help save a bundle on taxes. He is also the author of High-Profit IPO Strategies, All About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.