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What It Is
A capital gains tax is a tax on the increase in the value of an investment.
How It Works
A capital gain is the difference between the purchase price (the basis) and the sale price of an asset. The formula for capital gain is:
Sale Price - Purchase Price = Capital Gain
Note that this formula assumes the sale price is higher than the purchase price. If an investor sells an asset for less than he or she paid, this is called a capital loss, and no tax is owed.
Let's assume you purchase 100 shares of XYZ Company for $1 per share. After three months, the share price increases to $5. This means the value of the investment has increased from $100 to $500, for a capital gain of $400.
Taxpayers report capital gains on IRS Schedule D, but these gains are subject to different tax rates depending on whether they are short term or long term (and in some cases depending on the type of asset).
In the example above, if you sold the XYZ Company after a year, the IRS would consider your $400 profit a long-term capital gain and would tax it at one of several lower, flat rates. However, if you sold the XYZ Company shares after just three months, the IRS would consider your $400 profit a short-term capital gain and tax that $400 at your ordinary income tax rate, which is generally higher than the long-term capital gains tax rate.
Why It Matters
Some retirement vehicles, such as 401(k)s and IRAs, allow investors to buy and sell assets within these vehicles without becoming subject to capital gains tax. This tax deferral effectively gives investors a larger balance on which to compound interest or returns, with capital gains tax applying only when the investor begins to make withdrawals.
An investor's capital losses will sometimes offset all or a portion of his or her capital gains, lowering the investor's tax bill. There is a limit, however, to how much the investor can offset. Note also that the IRSdoes not treat the distributions of net realized long-term capital gains, like those from a mutual fund, as capital gains. The IRS treats those as ordinary dividends.
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