One thing that separates regular income and investment income is how the IRS views them when it comes to taxes. Knowing the differences between the two can not only save you from a surprise tax bill, but also put you in a position to take advantage of some capital-gain friendly perks.
Here are three must-know tax rules to protect your money from capital gains.
1. Taxes on long-term capital gains are different from taxes on ordinary income
To encourage investments, the IRS taxes long-term capital gains on property held longer than a year more favorably than regular income. Income taxes are divided into seven brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Capital gains operate in a simpler format, with the rates being 0%, 15%, or 20%. Here's how much you can expect to pay, depending on your income and tax-filing status:
|Income Range (Single Filer)||Capital Gain Tax Rate|
|$0 to $40,400||0%|
|$40,401 to $445,850||15%|
|$445,851 or more||20%|
|Income Range (Married Filing Jointly)||Capital Gain Tax Rate|
|$0 to $80,800||0%|
|$80,801 to $501,600||15%|
|$501,601 or more||20%|
The U.S. tax system is progressive, so the more money you make, the more you'll pay in income taxes. However, your tax bracket isn't the percentage that will be applied to all your income; each range of your income is taxed at the respective percentage.
For example, let's assume you make $100,000 annually. All $100,000 won't be taxed at 24%. Instead, here's how it will be taxed:
- The first $10,275 will be taxed at 10%: $10,275 * 10% = $1,027.50
- $10,276 through $41,775 will be taxed at 12%: $31,499 * 12% = $3,779.88
- $41,776 through $89,075 will be taxed at 22%: $47,299 * 22% = $10,405.78
- $89,076 through $100,000 will be taxed at 24%: $10,924 * 24% = $2,621.76
Instead of your tax bill being $24,000 ($100,000 * 24%), it will actually be $17,834.92. Capital gains, however, are taxed straight up. If you make $100,000 and have $50,000 in capital gains, the whole $50,000 will be taxed at 15%.
2. How long you've held the investment matters
The IRS defines capital gains and losses as either short term or long term. Short-term capital gains and losses come from investments you've held for one year or less, and anything you've held for longer than one year is long term. If you bought a stock on Jan. 31 and sold it in November of the same year, it would be short term. If you held that stock until March of the following year, it would be long term.
The length of time you've held the stock matters because short-term capital gains are taxed at your regular income-tax rate, which is likely higher. If you make less than $40,400, it's the difference between paying 12% and paying no tax on the capital gains at all. If you make $200,000, you'll go from 15% to 32%.
3. Capital losses can offset capital gains and other income on your tax bill
Fortunately, if you find yourself in a situation where you have to sell a stock at a loss, you may not take a full financial hit. Capital losses are fully deductible against capital gains. Moreover, if your capital losses are more than your capital gains, you can claim part or all of the excess amount on your taxes to lower your taxable income.
The limit on what you can claim is the lesser of the excess loss or $3,000. If your capital-gain losses exceed the $3,000 limit, you can carry the extra losses forward to later years.
Let's assume you sold shares of a company and made $5,000 in capital gains, but later sold shares in another company at a $7,000 loss. In that case, you'd have a net $2,000 capital loss.
If your taxable income was $100,000, you could deduct $2,000 to bring it down to $98,000. Had your capital losses been $4,000, you could've deducted $3,000 this year and rolled over the remaining $1,000 to next year.
Make sure you're knowledgeable
More than anything, you want to ensure a tax bill doesn't catch you off guard. If you're making money, the IRS wants its portion, and capital gains are no different. Knowing not only how much you've made (or lost), but also how much you owe in taxes, will help you be more efficient in your financial planning.