One of the main ways to profit from investing is to buy assets at one price
and then sell them at a higher price. These types of profits are known as capital gains.
As with most kinds of profits, they’re subject to taxes. Taxes can impact the growth of your
portfolio, so it’s important to understand how capital gains taxes work and learn some strategies
to potentially minimize them. Let me note up front that in this video we’re just covering the basics.
Taxes can be complex and vary based on a lot of factors, so it’s always best
to consult the IRS or a tax professional to understand your specific situation.
We’ll start with a simple example. Let's say you’re an average investor and have a regular
taxable brokerage account. You buy a share of stock XYZ for $50, and over the course of a year,
it increases to $60. At this point, you’ve gained $10, but it’s an unrealized gain,
because you don’t actually profit until your position is closed. No matter how long you hold
the stock or how much its price changes, you won’t be taxed on gains as long as you don’t close the
position and gains remain unrealized. Note that other types of income from stocks, like dividends,
may still be subject to taxes, but these may not be considered capital gains.
Now, back to our example. Let’s say you decide to sell the stock at $60.
That is considered a realized capital gain and is a taxable event.
You now owe taxes on the $10 profit. We’re focusing on stocks in this video
but be aware that capital gains taxes also apply to other types of investments like real estate,
bonds, and mutual funds. So, how much are capital gains taxed?
It mainly depends on two factors: how long you held the investment and your income level.
There are two types of capital gains: short term and long term. Proceeds from investments you sell
after holding for a year or less are generally classified as short-term capital gains.
They’re typically taxed at the same rate as your ordinary income, which is determined by the
marginal tax bracket you fall into. For reference, marginal tax rates for the 2020 tax year ranged
from 10% to 37%, but rates can change over time, so it’s best to check with the IRS for specifics.
Proceeds from investments held for more than a year are typically classified as long-term capital
gains. They’re usually taxed more favorably because the U.S. government views them as
providing economic benefit. The specific rate may still vary based on your income,
but for reference, the 2020 long-term capital gains rate did not exceed 15% for most people.
Again, rates can change over time, so it’s best to check with the IRS or a tax professional.
In most cases you report capital gains for the year as part of your annual tax return,
which could increase your tax liability when you file. If you realized any gains, it may
be a good idea to have money set aside in case you have to pay. Because taxes can significantly
impact the performance of your portfolio, it's important to be proactive in tax planning.
Here are a few strategies you can follow. First, weigh the pros and cons of short-term
investments versus long-term investments. Active investors may attempt to increase
returns by quickly buying and selling investments. However, because of increased taxes and fees,
it’s difficult for most people to outperform a well-diversified portfolio of long-term
investments that are almost always taxed at a lower rate. When planning your investment
strategy, consider how the investment holding period can affect your tax bill.
Second, consider maximizing tax-advantaged accounts, like retirement and education accounts.
Depending on the type of account, you may be able to buy and sell investments without being subject
to capital gains taxes. Reducing your tax burden could potentially help your portfolio grow faster.
Third, in taxable accounts, make the most of your losses.
Benefiting from losses may sound counterintuitive, but the IRS actually allows you to write off
certain trading losses, which can help offset some of your capital gains taxes. For example, tax-loss
harvesting is a strategy that involves closing certain positions to intentionally realize losses
that reduce your tax liability. Many brokerages offer automated tax-loss harvesting services,
but it’s not right for everybody, so be sure to check with a tax or financial advisor.
Of course, tax planning and some capital gains calculations can be confusing.
That’s why even seasoned investors enlist the help of tax professionals
to make sure their taxes are in order. Thanks for watching. Make sure you subscribe
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