What Are Capital Gains? A Guide to When These Taxes Apply
“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.