Capital Gains Tax Rates
There are two holding periods for capital assets sold:
If you're in the 15% tax bracket:
Computing Your Tax Bracket
There's one very important point that you must understand with respect to capital gains income. To determine your normal tax bracket for capital gains, your capital gain income is added to your regular income and you use the total... not just the portion related to your earned income. Then you're able to use Schedule D to compute your tax using a preferred tax rate on your long-term capital gain.
Please don't think that if you have $100 in other income and $1 million in long-term capital gains, that you're in the 15% bracket, and that all of your $1 million in long-term gains will be taxed at the preferred 10% rate. It's just not true. You have to add your $1 million to your $100 and then look at your tax bracket. The total would be considered "normal" for your income for that year -- and that amount would put you considerably beyond the 15% bracket.
So, while some of your gain would be taxed at the lower, preferred rates, the vast majority of the income would be taxed at the 20% long-term capital gain rates. In effect, once you "fill up" your 15% "normal" tax bracket with income (either regular income, capital gain income, or a combination of both), you'll move to the next tax bracket, and your preferred capital gain tax rate will move from 10% to 20%. As you'll see in a minute, you might have some Alternative Minimum Tax (AMT) implications to consider too... especially with a million-dollar gain. But a preferred 20% capital gains tax rate is still much better than a "normal" rate of 28% (the next bracket above the 15% bracket), and very much better than the 39.6% rate (the highest tax bracket).
Don't Forget About AMT Implications on Large Gains
Since we opened the door by mentioning a very large capital gain in our example above, we don't want to forget to mention Alternative Minimum Tax. You may have heard that the preferred tax rates for capital gains will not trigger the dreaded AMT. That's true... at least somewhat. For AMT purposes, you'll also receive a preferred capital gain rate on long-term capital gains. But, because of the workings of the AMT, a large long-term capital gain could trigger some AMT taxes. So if you've done well with your long-term investments and are looking to liquidate, at the very least you should review your AMT issues and determine what (if any) impact such a sale would have. If you look before you leap, you might be able to make decisions that will minimize your AMT taxes (such as selling only part of the shares in each of two taxable years).
Buy-and-Hold -- Foolish and Tax-Savvy
That's the lowdown on the capital gains tax rates. What does it all mean for you as a Foolish investor? Well, a quick glance at the numbers above reveals the most important implication: The longer you hold your stocks, the less tax you're probably going to pay.
One bone of contention between Fools and the Wise is the value of holding stocks for the long term. A Foolish investor usually tries to find great companies in which to invest, aiming to hold the stock for years (or decades) as long as the reasons for buying the stock remain unchanged. The Wise, though, will frequently assert that it can be more profitable to jump in and out of the right stocks at the right time, holding them until you reap the expected gain or until something better comes along.
Look at your own situation and tax bracket. For example, if you hold on to a security for longer than a year, you're likely to be paying 20% of your gain in taxes. If your holding period is a year or less, the gain could be taxed as much as 39%. With a mere $1000 gain, that's a difference of $190, or 19%. Are your short-term trading earnings going to be substantial enough to compensate for the fact that you'll be paying nearly twice as much in taxes? Not likely.
For more information on capital gains tax issues and other investment tax issues in general, you can always review IRS Publications 544 (Sales and Other Dispositions of Assets) and 550 (Investment Income and Expenses), available at the IRS website.