3 Things You Need to Know About the Capital Gains Tax

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If you sell an investment in a non-retirement account, you'll probably have to pay capital gains tax on your profits. While paying taxes is nobody's favorite activity, the more you understand how the capital gains tax works, the better-equipped you'll be to make wise choices with your investments -- and to keep your tax bill as low as possible. With that in mind, here are three things you need to know about the capital gains tax in 2016.

Not all capital gains are taxed equally
One thing investors need to be aware of is the difference between long-term and short-term capital gains. In the eyes of the IRS, a long-term gain refers to a profit made on the sale of an investment you've held for more than a year. On the other hand, a short-term gain was made on an investment you held for a year or less.

For tax purposes, short-term capital gains are taxed at your ordinary income tax rate. That is, if you're in the 25% tax bracket, that's how much you'll pay on your short-term gains. Long-term capital gains are taxed much more favorably, at rates ranging from 0% to 20%, depending on your income. Here's a table that can help you determine how much you'll be on the hook for if you sell a stock in 2016.

Data source: IRS. 

As an example, let's say you're considering the sale of a certain investment, and you're sitting on a $2,500 gain. If you're in the 25% bracket and sell after just 11 months, you're looking at $625 in federal income tax. However, if you choose to wait until you've owned the stock for at least a year and a day, your tax bill drops to $375.

Do you earn a lot of money? Your capital gains tax rate may be even higher
Since 2013, an additional "Net Investment Income Tax" is imposed on the investment income of high-income taxpayers. If a taxpayer's modified adjusted gross income (MAGI) is above a certain threshold, an additional 3.8% tax will apply to their net investment income in addition to the capital gains tax rates listed above.

Here are the current thresholds, depending on filing status:

Data source: IRS. 

For the purposes of this tax, net investment income includes capital gains as well as dividends, interest, rental income, royalties, non-qualified annuities, and income from businesses involved in trading financial instruments or commodities.

You may be able to get out of paying tax on some of your gains
The good news is that capital gains tax is only charged on your net capital gains. In other words, any losses can be used to offset profits for the purpose of calculating capital gains taxes -- known as "tax-loss harvesting."

For example, if you sell an investment at a $5,000 profit and another at a $2,000 loss during the same tax year, you'll only be responsible for paying capital gains tax on $3,000. Capital losses cancel out the same type of capital gains first -- for instance, a long-term loss will be used to offset a long-term gain before it can be used to offset a costlier short-term gain. However, if there are no long-term gains to offset, it can be used toward offsetting any capital gains you may have.

In fact, you can use up to $3,000 in capital losses to reduce your taxable income, even if you had no capital gains at all during the year. Any amount above $3,000 can be carried over to the next year.

So, if you're sitting on some losing investments, the tax benefits could give you the motivation you need to finally cut your losses and put that money to better use elsewhere.

A final thought
Capital gains taxes could change significantly from the current structure depending on the outcome of the elections this fall.

As one example, Bernie Sanders has proposed getting rid of the more favorable long-term capital gains rates and taxing all gains at the higher income tax rates. Hillary Clinton wants to increase capital gains taxes on the highest earners for investments held for less than six years, not just one. On the other end of the spectrum, republican candidate Ted Cruz proposes a 10% flat tax on capital gains, wages, dividends, etc. Donald Trump wants to keep the 0%-15%-20% long-term capital gains tax structure, but the 0% bracket would be expanded significantly.

My point is that this discussion and the capital gains tax strategies you can use now apply in 2016, but keep in mind that capital gains taxes in America could change significantly in the coming years, depending on who ends up in power in the government. Stay tuned.