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Use Long Term Capital Gains to Cut Your Tax Bill

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In an era where computers buy and sell stocks in a millionth of a second, the idea of investing for the long haul may seem old-fashioned. But there's nothing old-fashioned about saving money on taxes. Long term capital gains enjoy much lower tax rates than short-term traders have to pay, making buy-and-hold investing a lot more attractive than rapid-fire buying and selling.

Why you pay less tax with long term capital gains
When you sell a stock, any profit you earn over what you originally paid for the stock is a capital gain. If your investment has dropped in value since you bought it, then you'll realize a capital loss when you sell.

Capital gains are a form of income that is generally subject to tax. But the rate you pay on capital gains depends on two things: the total amount of taxable income you've earned in a given year, and the length of time you held on to the investment before you sold it.

Capital gains come in two categories: long term and short term. If you've owned an investment for exactly one year or less, then any gains will be short term. But once you've owned an investment for a year plus a day, then your gains become long term capital gains.

As trivial as that distinction may seem, the difference in tax rates is anything but trivial. For short term capital gains, you'll pay taxes based on your marginal tax rate, ranging from 10% to 39.6%. Moreover, for high-income taxpayers, the 3.8% Medicare surtax on investment income applies to capital gains as well, bringing the top effective rate to 43.4%.

For long term capital gains, however, lower maximum rates apply. What those rates are depends on your ordinary tax bracket:

  • If you pay 10% or 15% on your regular income, you'll pay 0% -- no tax at all -- on your long term capital gains.
  • For those in the 25% to 35% tax brackets, the maximum long term capital gains rate is 15%.
  • Top-bracket taxpayers will pay a maximum of 20% on capital gains if they're long term.

Even with the same 3.8% Medicare surtax applying to high-income taxpayers, long term tax rates that are 10 to 20 percentage points lower than short term rates clearly show the benefit of making sure you hold on to assets long enough to have any capital gains get treated as long term.

Special exceptions for collectibles
Unfortunately, tax laws always have complications. For certain types of assets, different long term capital gains rules apply. In particular, gains on collectibles, including art, stamps, or precious metals investments, don't qualify for tax-rate reductions compared to your ordinary rate, and a higher maximum of 28% applies.

Even worse, those higher rates apply not just to physical coins and bullion but also to most popular ETFs that own precious metals. For gold and silver, SPDR Gold (NYSEMKT: GLD  ) and iShares Silver (NYSEMKT: SLV  ) are treated as collectibles for capital gains purposes. The same holds true for platinum-group metals investments ETFS Physical Platinum (NYSEMKT: PPLT  ) and ETFS Physical Palladium (NYSEMKT: PALL  ) . Still, for some high-income taxpayers, paying 28% is better than the higher rates that apply at the top end of the tax brackets.

Make your gains long-term
Taking steps to turn your profits into long term capital gains is worth the effort. Especially when you have substantial gains, the difference in tax rates means a lot more money in your pocket and a lot less for Uncle Sam.

The best way to earn long term capital gains is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

Read/Post Comments (1) | Recommend This Article (4)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 10, 2013, at 10:54 AM, akutach wrote:

    Thanks Dan,

    Variable short/long rates make for a powerful tool in creating incentives for long(er) term investing. For a congress that sometimes talks about the scourge of high frequency trading, they would have but to slide the scale to have a 'nano-'term holding that would get yet another tax rate. I don't see that one coming any time.

    When calculating income, do capital gains contribute to determining the tax rate? For example, a person who earns money entirely through capital gains may have a 10% rate on earnings and interest income (let's say $10,000), but then have a million in capital gains. Does the capital gain contribute to establishing the earnings level and marginal rate before determining the actual tax rate on that gain? or would the person in situation get a 0% rate on the capital gains portion?

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