"What are capital gains?" you might wonder.
When you hear the phrase, you probably assume it applies only to wealthy investors—you know, those folks who can sit back and let their stock market payouts fund their mansions and yacht rides.
But the truth is, the minute you invest in almost anything beyond your 401(k) or IRA—even, for example, your employee stock purchase plan—you have the potential to realize capital gains. That’s because capital gains simply refers to the earnings on an investment (whether that’s a security or real estate) that an investor receives when he sells it at a greater value than what he paid for it.
In other words, if you buy a stock for $50 and sell it for $75, you’ve got $25 in capital gains. Or if you bought a house for $200,000 and sold it for $300,000, you’ve got $100,000 in capital gains. While it’s obviously a good thing to hold assets that appreciate in value, capital gains come with tax implications that investors should be aware of.
The Difference Between Short- and Long-Term Gains
Capital gains are taxable, so if you sell something at a profit during the year, it could affect your bottom line. The rate at which you’re taxed, however, varies, depending on when you sell the item.
For example, if you buy a stock or bond and sell it within a year, it’s considered a short-term capital gain, and it’s taxed at your regular income tax rate. But if you wait more than a year to sell it, that’s considered a long-term capital gain, and the rate at which it’s taxed depends on where you fall in the tax bracket.
For most investors, it’s taxed at 15% at the federal level, even if you fall into a higher tax bracket. So if your income falls somewhere within the 25% to 35% brackets, you would be taxed at 15%. (In 2014, for example, single filers who make more than $36,900 and up to $406,750 will pay 15% in capital gains tax.)
If you fall in the 10% to 15% income tax brackets—as a single taxpayer making less than $36,900, for instance—you actually don't pay any federal taxes on long-term capital gains. But if you’re in the 39.6% bracket (such as a single taxpayer who makes more than $406,750), you’re actually taxed at a higher 20% rate.
But the taxes don’t stop at the federal level. There are state taxes to consider too. “People often don’t even think about the state capital gains tax and the fact that most states don’t have any preferential treatment for capital gains,” says Chris Wills, director of wealth management at RW Rogé & Company in Bohemia, N.Y. “They’re taxable as ordinary income.” So depending on your state, that could mean you’re paying another 7% to 8% on top of the federal rate.
When Might I Actually Pay Capital Gains Taxes?
If your investments go no further than your 401(k) at work and a couple of IRAs, don’t let capital gains keep you up at night. “It really doesn’t apply to you from a taxability standpoint, because anything that happens in your 401(k) is sheltered,” says Janet Krochman, a CPA in Costa Mesa, Calif. “There’s no reporting of the capital gains.” Investment growth inside of those accounts grow tax-deferred, which means you won’t pay income tax on them until you start withdrawing money.
RELATED: Saving for Retirement 101
And if you own a home, capital gains aren’t a cause for concern either, unless you see some serious appreciation on your property. That’s because every taxpayer gets an exemption on the first $250,000 in gain on a primary residence, which means you don’t pay capital gains taxes on that first $250,000 bump in value, as long as you've owned and lived in your home for at least two of the past five years prior to the home's sale date. That means that unless you buy and sell your home in a very short period, you should be able to take advantage of this exemption. "So typically, buying and selling a home isn’t a big factor” in triggering capital gains taxes, Wills says. Even better news—because the exemption applies to each taxpayer, if you’re married filing jointly, you and your spouse could see an exemption of up to $500,000.
RELATED: Your Taxes: If You’re a Homeowner …
Here’s where capital gains does come into play: any investments you hold outside of retirement accounts. So if you’ve got a taxable investment account at a brokerage house, you will see capital gains every time you sell an investment for more than you paid for it. If you’re invested in mutual funds, the fund managers occasionally pay out capital gains distributions that result from the buying and selling of stocks and bonds that happens inside those funds.
Capital gains are typically reported to you (by your broker, for instance) on a 1099-B or 1099-DIV form.
What About Capital Losses?
The flip side of capital gains is capital losses. That’s when you sell a property or investment for less than you paid for it. When you realize a capital loss on an investment, such as a stock or bond, you can deduct it as a way to offset your capital gains, or use it to bring down your overall taxes—or both, depending on your tax situation.
However, there’s a cap. “There is a maximum amount of capital losses that you can deduct in any given year,” Wills says. “It’s $3,000, even on a joint return.” If you have more than $3,000 in capital losses in a given year, you can forward the unused losses to the next year. (And the next, and the next, if you saw a lot of losses.) For married filing separate taxpayers, the capital-loss cap is $1,500.
RELATED: Investing 101
Some investors use capital losses strategically. “You might want to look at your portfolio sometime in November and get in touch with your broker and say, ‘OK, this stock hasn’t gone anywhere this year and I’d like to get something that’s going to do better,’” Krochman says. “’Do I have something else that I’ve got a $3,000 gain in, so I can sell them both and net to zero?’”
Similarly, if you know you’ve got a big capital gains check coming in, you might consider selling something that’s doing poorly to offset the gain.
The Big Picture
In a nutshell, capital gains are simply income—so they’re taxed, just like your paycheck is.
So why the difference between short-term and long-term capital gains tax rates? “The economic system in the U.S. depends upon capital formation, and that requires savings and investment,” Wills says. “But in order for savings and investment to really be savings and investment—and not trading—it has to be longer term.”
In other words, the government doesn’t want to encourage you to day trade; they’d rather you buy investments and hold them for a while before you sell them—which is probably the most stable way for you to approach saving and investing, anyway.