Source: Flickr user Phillip Ingham.
Do your eyes glaze over when you hear the term "capital gains"? Unless you're a tax aficionado or spend a lot of your time surfing IRS.gov, you might be unfamiliar with the ins and outs of capital gains and how they can impact your portfolio's bottom line. Taxes can be confusing -- and boring, frankly -- but a basic understanding of capital gains may help you lessen your tax liability and keep more of your investment profits.
Read on for some basics on capital gains taxes, as well as some tips to reduce or eliminate them.
Understanding the capital gains tax
Capital gains are simply the profits earned when a capital asset is sold at a higher price than what it was purchased for. A capital loss occurs when a capital asset is sold at a lower price than what you originally paid. Gains and losses are unrealized -- meaning they're considered "paper" gains or losses -- until the investment is sold, at which point gains and losses are realized. For the purposes of this article, we're talking about realized gains and losses on investments (although other property, like cars and furniture, also counts as capital assets).
Capital gains taxes apply to investments held in taxable accounts -- not to investments held in individual retirement accounts or 401(k)s. The buying and selling that creates capital gains and losses can be done by the fund manager or by the investor holding the fund.
Capital gains are taxed in one of two ways. If you hold an investment for a year or less before selling, any gains will be treated as short-term capital gains. If you hold the investment longer than a year before selling, any gains will be classified as long-term capital gains. All realized capital gains must be reported to the IRS.
Generally, long-term capital gains are taxed at a lower rate than short-term capital gains. You pay your ordinary income tax rate on short-term capital gains, while long-term capital gains are taxed between 0% and 20% based on your tax bracket. Those in the highest tax bracket could be hit with an additional 3.8% Medicare surtax, effectively raising their capital-gains tax rate to 23.8%. Taxpayers in the lowest income brackets often have no tax liability on long-term capital gains, so the length of time you hold your investments can make the difference between paying substantial taxes and paying none at all.
This difference in tax treatment benefits long-term investors over those who frequently buy and sell, such as day traders.
You (or your investment advisor) may be able to lessen your capital gains tax liability. Here's how.
Tax-saving tips for investors
For your taxable accounts, you may look for mutual funds with lower turnover ratios, meaning there is less buying and selling within the fund and therefore less opportunity for capital gains. But remember that turnover ratio is just one of several factors to consider when evaluating a fund.
You can also wait to sell a particular investment until you've held it for more than a year. That way, any capital gains will be treated as long-term rather than short-term and may be taxed at a lower rate as a result.
And if you're currently looking to add a particular investment to your portfolio, you might consider waiting until after it makes its capital-gains distributions for the year. This typically happens in November or December, and anyone who owns shares on the record date will receive the distributions.
Lastly, this may sound extreme, but at times it might be worth considering selling a fund at a loss in order to offset your capital gains and help lessen your tax liability. This is known as tax-loss harvesting. When excess capital losses exceed your capital gains, those losses can be used to reduce other income on your tax return.
For example, if you and your spouse invest $50,000 in a mutual fund and sell those shares when they collectively drop in value to $40,000, you would lock in a $10,000 capital loss in the year the shares are sold. That loss can be used to offset up to $10,000 of capital gains in the same year.
In this example, if you have $5,000 in capital gains, they could be offset by the capital loss, leaving you with $5,000 of unused loss. Up to $3,000 of the remaining loss could be used to reduce your taxable income total in the same year -- if you file taxes jointly with your spouse -- leaving $2,000 of capital loss to carry forward to offset future gains or income.
Capital losses from the sale of personal property cannot be used to offset capital gains; only capital losses from investments can do that. This tactic isn't for everyone, so consider this only if it makes sense for your long-term investing strategy.
A few simple actions can help you keep more of your hard-earned money. If you have questions about what this means to you, contact an investment advisor or a tax professional.
