Capital Gains Taxes Explained

Upbeat music plays throughout.

Narrator: One of the main ways to profit from investing is to buy assets at one price and then sell them at a higher price.

These types of profits are known as capital gains. As with most kinds of profits, they're subject to taxes. Taxes can impact the growth of your portfolio, so it's important to understand how capital gains taxes work and learn some strategies to potentially minimize them. Let me note up front that in this video we're just covering the basics. Taxes can be complex and vary based on a lot of factors, so it's always best to consult the IRS or a tax professional to understand your specific situation.

We'll start with a simple example. Let's say you're an average investor and have a regular taxable brokerage account. You buy a share of stock XYZ for $50, and over the course of a year, it increases to $60. At this point, you've gained $10, but it's an unrealized gain, because you don't actually profit until your position is closed. No matter how long you hold the stock or how much its price changes, you won't be taxed on gains as long as you don't close the position and gains remain unrealized.

Note that other types of income from stocks, like dividends, may still be subject to taxes, but these may not be considered capital gains. Now, back to our example. Let's say you decide to sell the stock at $60. That is considered a realized capital gain and is a taxable event. You now owe taxes on the $10 profit.

We're focusing on stocks in this video, but be aware that capital gains taxes also apply to other types of investments like real estate, bonds, and mutual funds.

So, how much are capital gains taxed? It mainly depends on two factors: how long you held the investment and your income level.

There are two types of capital gains: short term and long term. Proceeds from investments you sell after holding for a year or less are generally classified as short-term capital gains.

On-screen text: 2020 tax brackets with short-term capital gains

Animation: Buckets show the breakdown of $82,000 in wages for a 2020 single filer using a standard deduction. $9,875 taxed at 10%, $30,250 taxed at 12%, and $41,875 taxed at 22%.

Narrator: They're typically taxed at the same rate as your ordinary income, which is determined by the marginal tax bracket you fall into. Capital gains are stacked on top of your ordinary income. So, let's say you earned $82,000 in wages. Any capital gains would be added to the top of that for tax purposes.

Animation: 22% bucket increases to $45,400, and an additional bucket appears that taxes $8,475 at 24%.

Narrator: So, if you saw $12,000 in short-term capital gains, it would count as part of your highest tax bracket. Capital gains could push you into a higher tax bracket if it pushes your income above the bracket limit.

For reference, marginal income tax rates for the 2020 tax year ranged from 10% to 37%, but rates can change over time, so it's best to check with the IRS for specifics.

Proceeds from investments held for more than a year are typically classified as long-term capital gains. For stocks, the long-term capital gains tax rates are generally much lower than the ordinary income tax rates.

On-screen text: 2020 long-term capital gains tax rates

Animation: Buckets show the breakdown of $200,000 in wages for a 2020 single filer using a standard deduction. $40,000 taxed at 0%, $160,000 taxed at 15%, and $0 taxed at 20%.

Narrator: As of 2020, the long-term capital gains tax rates were 0%, 15%, and 20%, depending on your income level.

The specific rate may still vary based on your income, but rates can change over time, so it's best to check with the IRS or a tax professional.

Also, if your income is over a certain limit, gains from your investments could also be subject to the 3.8% Net Investment Income Tax.

In most cases, you report capital gains for the year as part of your annual tax return, which could increase your tax liability when you file. If you realized any gains, it may be a good idea to have money set aside in case you have to pay, or, depending on your circumstances, plan to make estimated tax payments throughout the year.

Because taxes can significantly impact the performance of your portfolio, it's important to be proactive in tax planning. Here are a few strategies you can follow.

On-screen text: Consider holding periods

Narrator: First, weigh the pros and cons of short-term investments versus long-term investments.

Active investors may attempt to increase returns by quickly buying and selling investments. But when considering trading strategies, don't forget to factor in the tax implications. Capital gains taxes can take a big bite out of any profits. Because of increased taxes and fees, it's difficult for most people to outperform a well-diversified portfolio of long-term investments that are often taxed at the lower long-term capital gains rate. When planning your investment strategy, consider how the investment holding period can affect your tax bill.

On-screen text: Maximize tax-advantaged accounts

Narrator: Second, consider maximizing your tax-advantaged accounts, like retirement and education accounts.

Depending on the type of account, you may be able to buy and sell investments without being subject to capital gains taxes. Reducing your tax burden could potentially help your portfolio grow faster.

On-screen text: Make the most of your losses

Narrator: Third, in taxable accounts, make the most of your losses. Benefiting from losses may seem counterintuitive, but the IRS actually allows you to write off certain trading losses, which can help offset some of your capital gains taxes. For example, tax-loss harvesting is a strategy that involves closing certain positions to intentionally realize losses that reduce your tax liability.

Of course, tax planning and some capital gains calculations can be confusing. That's why even seasoned investors enlist the help of tax professionals to make sure their taxes are in order.

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