Having a new stock in your portfolio can make you feel like a kid who's just unwrapped a holiday present. After a long wait and careful study, you chose what you wanted and now it's there, bright and shiny in front of you (on your screen, not the living room floor, of course).
If shares of that stock rise, it can also be exciting to sell the stock and pocket some gains now that your initial investment is paying off. Unfortunately, there's a twist we all must face that saps some of the joy, just like going back to school when the holiday is over.
We're talking, of course, about capital gains taxes.
If you happen to sell a security, some other investment, or another asset at a higher price than you bought it, you've created a capital gain. That's considered income by the Internal Revenue Service (IRS) and, like any other type of income, Uncle Sam wants his share. (If you sell and lose money on the asset, that's considered a capital loss and has a different set of tax consequences—but that's another discussion.)
What are capital gains?
From the standpoint of the IRS, capital gains are additional income and must be reported as such. Strictly speaking, the IRS considers any gain on any asset fair game. The gain is calculated by subtracting the adjusted cost basis of the asset from the amount you realized on the sale. That includes boats, cars, and stocks, as well as the profit you might make from selling that retro pair of basketball sneakers or your prized 1952 Mickey Mantle baseball card.
What's the difference between long-term and short-term gains?
In terms of taxes, plenty, according to the IRS. Assets that you hold for longer than a year qualify as long-term gains and are taxed at lower rates than ordinary income, which can give you a significant tax benefit. A profit on anything held for less than a year is classified as a short-term gain and is taxed at the same rate as your ordinary income, so there's no unique tax benefit tied to them.
If you buy and sell an asset during a one-year period and make a profit, that's considered ordinary income and booked as a short-term gain. (There are some exceptions, such as gifts and inheritances.)
What are the capital gains tax rates?
For 2022 until at least 2025, if you record a short-term profit and add it to your ordinary income, the ordinary tax rates range from 10% to 37%. The maximum tax, if it included the 3.8% Net Investment Income Tax (NIIT) applied to individuals, estates, and trusts that have income above the statutory thresholds, would be 40.8% on short-term gains.
Hold on to that asset for longer than a year before you sell it, and it falls into the long-term gains column. (Certain capital gains tied to partnership interests held in connection with the performance of investment services now require a three-year holding period to be called a long-term gain. Again, that's another discussion.)
Could tax rates for long-term gains change?
Possibly. As of 2022, the tax rates for long-term gains rates range from zero to 20% for long-term held assets, depending on your taxable income rate. For the present, long-term capital gains taxes do not exceed 23.8%, including the 3.8% NIT.
- Your taxable income (single)
- Your taxable income (married filing jointly)
- Long-term capital gains rate (as of 2022)
Your taxable income (single)$0-$40,400>Your taxable income (married filing jointly)$0-$80,800>Long-term capital gains rate (as of 2022)0%>
Your taxable income (single)$40,401-$44,850>Your taxable income (married filing jointly)$80,801-$505,600>Long-term capital gains rate (as of 2022)15%>
Your taxable income (single)Above $445,850>Your taxable income (married filing jointly)Above $505,600>Long-term capital gains rate (as of 2022)20%>
However, elections do happen and power in Washington, D.C., changes, making it important to keep an eye on the White House to see if those rates change. Back in the late 1970s, the maximum long-term capital gains rate rose to near 40% for some investors with the biggest gains. The maximum rate recently fell to its lowest level ever.
When it's time to cash out some of your capital gains, timing can be important. If an investor thinks Washington is likely to change rates soon, they might decide to hold on a bit longer if they think rates might go down or decide to get out earlier if they think rates could rise. It's up to the individual investor, of course, and depends on how quickly they need their profits.
What about special taxation rules for derivatives?
If an investor trades futures, options on futures, or options on broad-based indexes, such as the S&P 500® (SPX) or Nasdaq-100® (NDX), they get to claim special "marked-to-market" status under section 1256 of the U.S. Internal Revenue Code.
Under this rule, regardless of whether an investor liquidated a position by the last trading day of the year, the IRS treats it as if they did and uses the closing price of that final trading day to figure the investor's unrealized gain or loss. The closing price is "marked" and used as the cost basis going forward.
The profit and loss for tax purposes is split into two capital gains buckets—60% is considered long-term capital gains and 40% is short-term capital gains—regardless of how long you held the position.
Tax policy, marginal rates, and capital gains taxes can border on the complex—and can sometimes be a moving target. And these are only federal rates; Many states tack on their own capital gains taxes. For details about your own personal tax situation, consult a tax or estate-planning professional.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
No tax advice is provided or intended. Please consult with a tax-planning professional with regard to your personal circumstances.0223-3SR1