We all know we get taxed many different ways, and it’s important to understand them all at least to some degree. I want to focus on the capital gains tax and how we can use these rates to our advantage.
Capital gains happen when you sell something for a gain. Each year, the IRS requires you to report all your capital gains and losses for the year and there are three important things you should know about how these taxes work.
1. There are short-term and long-term capital gains taxes.
Short-term gains are taxed at your regular income tax rates which means they are no different than receiving regular income.
Long-term gains are taxed at lower rates than your regular income. The idea here is to encourage investment over longer periods so that companies have a steady source of capital for future growth.
For the most part, what defines whether you have a short- or long-term gain is the period of time you held the investment. If you hold something for longer than 1-year it is typically going to be taxed at the lower, long-term rates. One potential exception is your ESPP, which depends both on your holding period and on the period since the offering date.
2. You get to offset capital losses and capital gains.
If you have a large capital loss for whatever reason, you can use that to offset current and future capital gains for tax purposes. This means that suffering a loss actually creates a tax asset that can be used to lower your taxes in the future.
3. Your capital gains tax rates increase with the amount of income you make, including your capital gains.
If you are married filing jointly, you can have up to $80,000 of taxable income including your capital gains and pay no capital gains tax. Of course, you’ll still have to pay regular income tax on any regular income you have, but you can realize capital gains completely tax-free.
If you’re married and your income is between $80,000 and about $500,000, your long-term capital gains tax rate is just 15%. Of course, there is an additional 3.8% tax if your income is over $250,000 just to make it confusing.
Above $500,000 in income, your long-term capital gains tax rate is 20%.
What does all this mean?
It means you should be aware of how much income you will have each year as you make decisions to sell stock or other investments that creates gains or losses.
One final note. The way taxes are calculated is changing all the time. Regarding capital gains, there were some minor changes made during the Trump administration.
Today, under the Biden administration, there are some rather major changes on the table that could go into effect later this year.
For that reason, it is important to work with your Financial Planner and Tax Advisor to chart the best path for you.