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Breaking Even: Short-Term vs. Long-Term Capital Gains by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research May 11, 2006 Changes to the tax law back in 2003 made an already great strategy—holding investments for the long term—a better deal than ever. To recap, gains on stocks, bonds and mutual funds held over one year are taxed at a maximum federal long-term capital gains rate of 15%.* Short-term gains (on investments held one year or less) are subject to ordinary federal income tax, which ranges up to 35%. If you're thinking of selling an investment, and in just a few days or weeks you'll have held it over one year to qualify for the long-term capital gains rate, you may want to wait. But what if you’re months away from the year-and-a-day benchmark? Is it worth postponing the sale and holding out for the 15% long-term rate? Of course, the investment decision should always come first. After all, your gains could evaporate while you hold out for a better tax rate (that’s one way to minimize taxes). That said, taxes can represent the biggest drag on your investment returns. All else being equal with respect to your investment outlook, it makes sense to factor in the potential tax hit when deciding whether to sell—and that includes calculating the value of holding out for long-term tax treatment. A hypothetical example To illustrate, let’s say you bought a stock in your taxable brokerage account nine months ago. Your stock has already jumped 20% in value, an increase you expected would take a lot longer. You have a healthy short-term gain on paper, and you're wondering if you should sell now or wait three months for the 15% long-term tax rate to kick in. The obvious risk is that the stock price could go down during those three months. How low can it go before waiting for long-term capital gains treatment cuts into your after-tax profit? Calculating your break-even price The break-even price is the sale price at which your after-tax profit on a security is the same whether you receive short-term or long-term tax treatment. Calculating your break-even price isn't overly complicated, depending on your spreadsheet skills. You’ll need to know your federal and state ordinary income tax brackets (for short-term gains) as well as your federal and state long-term capital gains rates. Expanding on our hypothetical example, suppose you purchased 100 shares of XYZ at $50 per share nine months ago. Your cost basis is $5,000 (excluding commissions) and the stock is currently trading at $60 per share, giving you a 20% unrealized gain. If you sell now and take a $1,000 gain, you'll have to pay short-term capital gains tax on your federal and state income tax returns. But if you wait until you’ve held the stock for at least one year and one day before you sell, you’ll be taxed at potentially lower long-term rates. How low could you let the price of XYZ drop and still realize the same net, after-tax profit? The answer, of course, depends on your ordinary marginal tax brackets. Let's assume your federal bracket for ordinary income tax is 35% and you live in California, where the top ordinary bracket for state income tax is 9.3%. Your federal long-term capital gains tax rate is 15%, and California's long-term capital gains tax rate is the same as it is for ordinary income: 9.3%. We’ll further assume your state taxes are fully deductible on your federal income tax return. For those who are handy with spreadsheets, see below for how you might set up a do-it-yourself break-even calculator (cut-and-paste won’t work, you’ll have to enter the formulas yourself). If you’re a Schwab client, you’re in luck. Simply log in to access Schwab’s Sell Analyzer and you can figure out the long-term break-even sale price for an individual stock, bond or mutual fund. If you're thinking of selling now and purchasing an alternative security, you can also figure out its break-even price over the same period (the Sell Analyzer will look up the current price, and you can even account for commissions). Hypothetical after-tax break-even price
Excludes commissions. Break-even price if held for long term = Purchase price + ((((Number of shares x Current price) - (Number of shares x Purchase price)) - (((Number of shares x Current price) - (Number of shares x Purchase price)) x (Federal bracket + (State bracket x (1- Federal bracket))))) / (1 - (Federal long-term capital gains rate + (State long-term capital gains rate x (1 - Federal bracket)))) / Number of shares) Proceeds = Number of shares x Current price Less cost basis = - (Number of shares x Purchase price) Taxable gain = Proceeds + Less cost basis Less tax liabilities = - (Federal bracket + (State bracket x (1 - Federal bracket))) x (Proceeds - (Number of shares x Purchase price)) Note: State tax deduction is applied to ordinary marginal rate, assumed fully deductible. After-tax proceeds = Proceeds + Less tax liabilities In our hypothetical example, if you hold the stock for longer than a year, the price can drop as low as $57.47 per share and you’ll be no worse off than if you sold today at $60. That's your break-even price. At $57.47 per share, you would recognize a long-term gain of $747, on which you would pay $157 in federal and state income taxes (again, assuming full deductibility of state taxes on your federal return, and excluding commissions). Your net gain will still be $590, the same as if you sold today at $60 and incurred short-term capital gains tax treatment. The bottom line Don't become so wrapped up in tax calculations that you lose sight of making good investment decisions. At the same time, if you want a true picture of what you’re actually earning on your investments, it’s important to factor in all the costs associated with your buy/sell decisions, particularly taxes—this includes calculating the break-even price for long-term tax treatment. As always, check with your financial advisor or tax advisor before you make any transaction that could have significant tax implications. *A special 5 percent long-term capital gains and qualified dividend tax rate applies to taxpayers below the 25 percent bracket, with that rate going to zero after 2007. Tax rates on long-term capital gains and qualified dividends are scheduled to revert to pre-2003 law after 2010. The information presented does not consider your particular investment objectives or financial situation and does not make personalized recommendations. This information should not be construed as an offer to sell or a solicitation of an offer to buy any security. The investment strategies and the securities shown may not be suitable for you. We believe the information provided is reliable, but Charles Schwab & Co., Inc. ("Schwab") and its affiliates do not guarantee its accuracy, timeliness, or completeness. Any opinions expressed herein are subject to change without notice. (0506-6342) Return to Top |