In the world of investing and taxes, you'll run across long term capital gains and short term capital gains. Long term capital gains refer to gains from investments that you held for more than a year, while short term capital gains are from investments held for a year or less. In just about every way, long term capital gains are preferable. Here are three reasons to love long term capital gains.
You're not day trading
One of the least profitable ways to "invest" is to day trade. That typically involves jumping in and out of stocks frequently, owning them for perhaps just a few hours. The goal is to make a quick profit and get out, and then repeat the process -- many, many times. Studies have shown that about 80% or more of day traders lose money. One of the factors hurting the performance of many day traders is the cost of commissions for so many trades, and another is the taxes they have to pay on any gains. Imagine, for example, trading just twice per day every weekday for a year, paying $5 for each trade. That amounts to $2,500 spent on commissions alone!
Day trading has wiped out so many people that the Securities and Exchange Commission has a special page devoted to warning people about it. Thus you can be pleased with yourself if you're sitting on some long-term capital gains -- because it means you aren't even close to being a day trader.
You're staying focused on the big picture
Seeing a bunch of investments in your portfolio that have generated long term capital gains is a promising thing, because it suggests that you're being a smart and patient investor. Many stocks that we buy don't perform as we expected them to in short order. Think of Apple, which languished for many years before becoming one of the most valuable companies on earth. Or IBM and Xerox today, which, like many others, are in the process of reinventing themselves.
Sometimes we have to wait years for a company's true value to be realized. Some terrific companies start off small and promising and then become valuable large-cap companies over many years. Those kinds of investments are what make many people rich. Remember that Warren Buffett has said that his favorite holding period is "forever."
Being a patient investor also means not selling out of fear if the market or a particular stock you believe in heads south for a while. Doing so can turn a potential long term capital gain into a short term gain. Netflix, for example, has averaged 40% annual gains over the past decade but was quite volatile during that period. When it announced it was splitting itself in two and calling its DVD-by-mail business Qwikster, the stock plunged, generating lots of short term capital gains and losses for those who bailed. True believers held on, saw the idea canceled -- quite qwikly, in fact -- and have been rewarded, with the stock rising more than sixfold since then.
You'll owe less in taxes
Finally, a big reason to love long term capital gains is that they save a bundle in taxes. That's because tax rates are different for long term and short term gains. Short term capital gains are taxed at your ordinary income tax rate, which can top 40% for some folks. Long term capital gains, though, get hit with a tax rate of zero for those in lower brackets and 20% for those in the highest brackets (plus a 3.8% surtax for high earners). Most of us, though, face a long term capital gains tax rate of just 15%.
Clearly, there's a lot to like about long term capital gains. That's so true that some folks try to hold on to assets long enough to get the lower tax rate. That can be smart, but not always. It's usually best to focus on the quality and valuation of your investments first and let taxes be a secondary concern.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, owns shares of Apple and Netflix. The Motley Fool recommends Apple and Netflix and owns shares of Apple, IBM, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.