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Capital Gains
Understanding Capital Gains
When managing your portfolio it’s crucial to understand capital gains because if you’re not careful, you could end up paying much more in taxes than you bargained for! On the other hand, if you understand how capital gains are taxed you may actually be able to minimize the amount of taxes you’ll have to pay!
What is Capital Gain?
Capital gain is any income derived form the sale of an investment. It’s simply the difference between what you paid for a stock or mutual fund and how much you sold it for. For example, if you bought 100 shares of XYZ Corp. for $2,000 and sold the investment later for $2,500 the $500 difference would be your capital gain.
The Bad News: Capital Gains are Taxable
While it’s nice to have capital gains on your investments, the bad news is that most capital gains are taxable in the year in which you sold the investment. As long as the investment was made in a taxable account and not a 401(k) or IRA, you’ll have to pay capital gains taxes.
The Good News: You Can Control How Much Tax You Owe!
Whether you like it or not, Uncle Sam will take a piece of that capital gain…but you do have some control over just how much the government will get! The key to minimizing how much tax you’ll have to pay on your capital gains is how long you own the investment.
Short-Term Capital Gains: Investments held less than one year are considered ordinary income and taxed at your marginal tax rate (the same as your wages).
Long-Term Capital Gains: Investments held longer than one year are taxed at 20% unless you’re in the 15% federal tax bracket and then you’re capital gains are taxed at 10%.
How does all this affect your portfolio?
Let’s assume that you bought 1000 shares of XYZ stock for $5 a share for a total investment of $5,000. If XYZ shares rose to $15 a share, your investment would be worth $15,000. If you were to sell your XYZ shares, you’d have a taxable capital gain of $10,000.
If you held your XYZ shares for less than a year, the capital gain would be treated as ordinary income and if you were in the 33% Federal tax bracket, you’d owe $3,300 in Federal taxes alone!
If you held the XYZ stock longer than a year, however, you’d only have to pay a 20% capital gains tax or $2,000!
Over time, the difference between paying short and long-term capital gains can certainly add up. It’s important to keep this in mind when selling any investment because the additional taxes paid on short-term capital gains can erode your portfolio’s returns!
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