Image source: Flickr user Global X.
The goal of every investor is to earn a profit on their investments. In most cases, the IRS also stands ready to claim its share of your hard-won profits, but the amount you'll pay in capital gains taxes depends on how long you own an investment. The higher short-term capital gains tax rates that have prevailed for years will once again apply in 2016, but there are things you can do to avoid paying those high rates.
What are this year's rates?
Short-term capital gains tax rates apply to gains on the sale of investment that you owned for a year or less. You'll pay your ordinary federal income tax rate on short-term capital gains, and that tax rate depends on your income-tax bracket. You can find a complete list of 2016 tax brackets here, but for purposes of illustration, let's take a look at the brackets for joint filers.
Married filing jointly or qualifying widow(er):
| Over | But not over | of the amount over | ||||
|---|---|---|---|---|---|---|
| $0 | $18,550 | N/A | + | 10% | $0 | |
| $18,550 | $75,300 | $1,855 | + | 15% | $18,550 | |
| $75,300 | $151,900 | $10,367.50 | + | 25% | $75,300 | |
| $151,900 | $231,450 | $29,517.50 | + | 28% | $151,900 | |
| $231,450 | $413,350 | $51,791.50 | + | 33% | $231,450 | |
| $413,350 | $466,950 | $111,818.50 | + | 35% | $413,350 | |
| $466,950 | $130,578.50 | + | 39.6% | $466,950 |
Table by author. Data source: IRS.
Note that these brackets apply to your entire taxable income, not just the portion of it that's represented by short-term capital gains. As a result, you can't figure out your true short-term capital gains tax rate until you know your total income. For those who earn more than $466,950 in taxable income, short-term capital gains will get taxed at the highest 39.6% rate. Those making less than $18,550 will pay 10% in taxes on short-term capital gains, and those in between will face a range of different tax rates.
Cutting your capital gains tax bill
If these rates seem high -- and many think they are -- then there are a few things you can do. If you invest in a tax-deferred account, then you can buy and sell stocks at will without worrying about immediate tax consequences from gains or losses on their sale. In most cases, you'll either pay taxes only when you withdraw money or you'll avoid taxes entirely in a Roth IRA or other Roth-style retirement plan.
Second, if you have the option of waiting to sell until you've held an investment for longer than one year, you can qualify for lower long-term capital gains rates. This can result in paying no tax if you're in the 10% or 15% bracket, and lower rates of 15% to 20% for those in higher ordinary income tax brackets.
Finally, bear in mind that if you have investments on which you have lost money, selling them to generate short-term capital losses can allow you to offset gains. Tax-loss harvesting is a popular strategy to cut your overall tax bill.
Having short-term capital gains means that you've made a lucrative investment, but it's still important to preserve as much of your profit as possible from the grip of the IRS. By being aware of high short-term capital gains rates and taking steps to avoid them, you can keep more money in your pocket.
