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What Are Capital Gains and How To Calculate Them

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Capital Gains are a part of investing. But don't be afraid to sell! Tax season is easier than you think.

Buy low, sell high. You’ve probably heard this before if you’ve ever gotten investing advice! It’s the first piece of investing advice that I ever got.

I was so nervous to buy and sell my first investment, but when I followed this advice, I actually made some money on my initial investment!

At the time, I didn’t yet realize that I would actually have to pay taxes on what I had made! The part of your investment that’s money in your pocket when you sell high is called capital gains.

It’s the whole reason behind investing in the first place, and it might be news to you like it was to me that this is taxed. You might be wondering why this income needs to be taxed, but in reality it is income, and the IRS sees it as such.

So, What Exactly Are Capital Gains

Think of taking a trip to a casino. You’ll most likely bring some spending money to play with. In his college days, my husband played a slot machine and had some great luck.

He didn’t expect to make any money to take home, but there’s always a chance! As a broke college student, he brought $20 to play, and came home with $30. In investment terms, he had $10 of capital gains.

The whole $30 he took home wasn’t capital gains, but the $10 portion that he didn’t start out with was considered a gain. This is how capital gains work. Money you didn’t start out with, but “won” through wise investments counts as your capital gains.

The good news is, you get to keep this! The bad news is, it’s taxed. We’ll talk more about this later.

Another key detail to note about capital gains is the fact that they don’t really “exist” until the stock or asset you bought has been sold. So, if your stock is just gaining value over time, it won’t be taxed (this would be called an unrealized gain).

However, when you sell the stock and it has gained value, this increase in price will be taxed, and dubbed realized gain, which is just another term for capital gains.

Capital gains can apply to anything that counts as an asset you own, gained money on and are cashing in.

Think of your home, a stock, a piece of fixer-upper furniture you flipped and sold, even cryptocurrencies! For the sake of clarity, I’ll chat about capital gains scenarios that apply to stocks.

Okay, back to the taxes.

Dealing with your capital gains as an investor isn't scary.

Taxes and Your Investments

So when you gamble, that income is taxed just like your regular income (you have to put this income on your tax forms when you’re filing). Short-term capital gains are taxed just like this! The IRS treats this income as if you just earned that money from working.

Short-term equals a year or less in this scenario. So, it can affect your tax bracket and cause you to pay a higher tax percentage, if the added income from your capital gain bumps you to a new tax bracket.

Long-term capital gains get a bit more complicated. These are qualified as capital gains that have accrued over more than a year.

Let’s say today I decide to sell an investment I made in 2018, and buy into another stock instead.

I have some Apple stock that’s increased quite a bit over that time, and now I’ll have to pay a special capital gains tax on this income I made, since the gains have been building over the past three years. But I’m only paying a tax on the profits I’ve made on my initial purchase over that period.

So, if I initially invested $2,000 and now have $6,000, I’ll pay taxes on $4,000 – or the capital gains.

I can pay these taxes as estimated tax payments (before filing my taxes) if I think I’ll owe the IRS $1,000 or more, or I can pay when I file my taxes for that year if I think it will be $1,000 or less.

If, say, my investment actually lost money, I won’t have to pay taxes on that transaction since it was a loss. Actually, if you incur a capital loss, it can be deducted from your taxable income as whatever’s less: your total loss, or $3,000.

In 2020, the rates of the long-term capital gains tax ranged from 0% to 20% and depended on your income level. If you’re filing as a single individual, and you make:

  • up to $40,000 – you’ll pay the 0% tax
  • from $40,001 to $441,450 you’ll pay the 15% tax, and
  • from $441,451 and up you’ll pay a 20% tax

If you’re filing jointly as a married couple like me, here are your applicable rates:

  • up to $80,000 – you’ll pay the 0% tax
  • from $80,001 to $496,600 you’ll pay the 15% tax, and
  • from $496,601 and up you’ll pay a 20% tax

Before you get overwhelmed with the amount of taxes you’ll have to pay, there’s some good news.

With both short and long-term capital gains, generally this is the only major tax you’ll need to pay when investing, and it only applies if you make money on your investments when you sell them.

You might wonder why people trade with short-term investments at all if the taxation is higher?

Well a few scenarios might offset the taxes. If you’re interested in playing the market with some disposable income, you could definitely compensate for the taxes with your earnings by profiting from your sales (for most of the middle class, we’d just have to make more than 22% to offset).

And you can also trade within a retirement account without taxation, which we’ll talk more about later.

One thing I realized when I decided to hold on to that Apple stock I own was that the best decision for me to make would be to keep my investment for over a year so my capital gains could count as long-term capital gains.

That way, I wouldn’t be taxed the 22% for my tax bracket, but rather the 15% for the special capital gains tax because of my current income. Make sure you assess your personal situation and tax bracket before deciding what’s right for you.

Now that you know how they work, what are some practical steps when you need to deal with capital gains and the taxes associated with them?

1. Track your capital losses

Like I mentioned before, if you have any investments you’ve sold at a loss during the same tax year, this can actually offset your capital gains!

So, if I had a capital loss of $3,000 on a stock I sold in the same year as gaining that $4,000 from my Apple stock I spoke of earlier, I would only owe taxes on $1,000 of my gains ($4,000-$3,000). Remember you can offset gains with losses.

2. Invest for retirement

When you open a retirement account, you can buy and sell within that account without these gains being subject to taxation.

When you go to withdraw from your account for qualified retirement purposes, the gains will be taxable (unless your account is a Roth IRA, which aren’t taxed when you make withdrawals, but rather when you contribute), but in the meantime you can save for retirement and buy and sell within the account without taxes.

I have my retirement account set up as a portfolio that is managed by professionals that buy and sell stocks within the portfolio when they see fit.

This is a great way for me to make money on my investments without the stress of capital gains tax!

3. Be patient

One more obvious step to alleviate higher taxes on your capital gains includes investing with a long-term mindset.

This way, you won’t have multiple scenarios (if you bought and sold stocks several times in a year) that require reporting and taxation of the income you’ve made on your investments.

I’ve decided to keep my Apple stock invested for the long term so I don’t have to deal with reporting the capital gains and being taxed quite yet.

The Bottom Line

If you’re already active in the investment world trying to buy low and sell high, you’ll definitely encounter some scenarios where you’ll need to deal with capital gains!

It’s a great thing to have to think about – it means you’re making money!

However, it’s also great to realize when and how to sell your stocks to make the most of your investments and subject them to as little taxation as possible.

Remember that you have options – you can find out if the investment you want to sell would have long-term or short-term capital gains, and you can also offset those gains with your capital losses.

You can also buy and sell stocks within the confines of a retirement account to avoid taxation. Then you’ll make the most of your investments while staying ahead of your taxes!

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