Barbara O’Neill, Extension Specialist in Financial Resource Management
Rutgers Cooperative Extension
Understanding Capital Gains on Investments
Paying income taxes is an unpleasant fact of life. Since we are in the middle of income tax season, an article related to capital gains taxes seems appropriate. When an investor sells securities and earns a profit, capital gains are realized and income tax is due. Conversely, an investment sale can also result in a capital loss. When this happens, the capital loss can be used to offset capital gains earned on other investments.
A capital gain is the increase in value of a capital asset such as real estate or investments (e.g., stocks, bonds, and mutual funds). In other words, people realize capital gains when they “buy low” (e.g., stock purchased for $10 a share) and “sell high” (e.g., stock sold for $20 a share). The difference between the amount paid for an asset and the amount for which it was sold is the capital gain.
In more technical terms, when investors sell a capital asset, the difference between its basis (a.k.a., cost basis), which is generally the amount paid for it, and its sale price is a capital gain or loss. Capital gains may be short-term or long-term, depending upon an investment’s holding period.
A short-term capital gain is a gain made on capital assets that are held for a year or less and a long-term gain is a gain on assets held more than one year. Both types of capital gains must be claimed on tax returns that determine an investor’s income tax payment, but they are taxed very differently.
It is wise for investors, especially those with significant assets, to monitor their tax withholding status. If additional withholding is needed to cover the taxes due on investment capital gains, investors have two possible strategies. One is to set aside a portion of their investment profit and use it to pay quarterly estimated taxes to the IRS. The other is to adjust their W-4 form at work to have their employer take more tax withholding out of their paychecks with which to pay investment-related taxes.
Short-term capital gains are taxed as “ordinary income.” This means income other than long-term capital gains, such as salaries, based on an investor’s marginal tax rate, which is determined by tax filing status (e.g., single, married filing jointly, head of household, etc.) and household taxable income.
Long-term capital gains are taxed at a lower capital gains tax rate. Long-term capital gain (LTCG) tax rates on 2018 federal income tax returns range from 0% to 20%, depending on an investor’s taxable income and tax filing status. Ideally, investments should be held long term to receive more favorable tax treatment.
As of 2018, capital gains tax rates no longer match up directly with federal income tax brackets. Rather, in 2018, the first full year of the Tax Cuts and Jobs Act, single taxpayers with taxable incomes of under $38,600, $38,600 to $425,800, and over $425,800 will pay long-term capital gains tax rates of 0%, 15%, and 20%, respectively. Married couples filing jointly earning under $77,200, $77,200 to $479,000, and over $479,000 will also pay long-term capital gains tax rates of 0%, 15%, and 20%, respectively. Other income ranges also apply for married couples filing separately and heads of household.
Mutual fund investors can earn taxable capital gains when the mutual funds they invest in sell securities and realize a profit. In other words, the gain is realized by a fund, itself, rather than by individual investors who sell securities profitably. In this situation, investors receive information from the fund that lists the amount of the distribution and the amounts that are classified as short-term and long-term capital gains.
If you have capital gains as part of your taxable income, be sure to set aside withholding for your income tax liability accordingly. This can be done by over-withholding for income taxes on capital gains through an employer or sending the IRS quarterly estimated payments.
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