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Stocks: Understanding Long-Term vs. Short-Term Capital Gains Tax

Stocks are exciting. 🤩The rollercoaster emotions with volatility, the little dopamine rushes when you earn $2 in dividends, and so on. One thing that isn’t very exciting about stocks is taxes. We're here to give you a few tricks that can make taxes fun in the best possible way: saving money (Even how to pay $0) 🤑. Let's dive in.

Just like how we research companies and investing strategies to make smart decisions, it’s important to grow our knowledge of the tax system, to make profits here as well and avoid “unnecessary taxes” 📈. The profit that we make from stock investments is called “Capital gains”. So, this article will explain everything you need to know about capital gains tax and different ways to minimize how much you need to pay. 💰

What are Capital Gains? 🤔

Simply put, when we make a profit on the sale of an asset, specifically real estate, stocks, and personal property, we must pay taxes on that gain.

Now, the government not only takes its cut/share from your income, but it also wants its share on any profits/gains realized from any capital investment, and this is commonly known as capital gains tax. Now, the word "realized" is very crucial for taxation purposes, and understanding the difference between unrealized and realized gains is important.

A gain will be considered as unrealized as long as the asset is not sold at an appreciated price. For example, if you bought stock in a company for $10 per stock, and two years later, its value reached $18 per stock. There was an increase in the value of the stock, but the government cannot tax you unless you sell that stock and “realize” or “cash-in” the profit. Think about how if you bought the stock at $10, and now it's $18, you wouldn't make the $8 until you sold the stock or realized your profits. Now it also matters when we choose to realize the profits or sell our assets, as we will be hit with different taxes.

Short Term Capital Gains Tax: The gain/profit realized when an individual sells capital assets after holding them for 12 months or less. As far as these capital gains are concerned, the tax rates for them are almost the same as the US marginal tax bracket for income tax.

Long Term Capital Gains Tax: The profit/gain realized when an individual sells capital assets after holding them for more than 12 months. Tax rates for these gains are discussed later in this article.

In the United States, under normal circumstances, long term capital gains

📈 are more favorable in terms of taxation as tax rates are much lower than short term capital gains 📉. Let’s take an example of how capital gains are taxed.

Taxation on Capital Gains Explained With an Example

Let's say you bought stock (100 shares) of a company named ABC where the price per share is $20. Now, assume that you sold those shares for $50 each after holding them for more than a year. Suppose, based on your income category, the tax rates for your long term capital gains is 15 percent. Your gains and taxes are calculated as follow:

Since you sold the asset after owning them for more than 1 year, you paid long term capital gains tax. The amount of tax you pay is dependent on your income range. The charts below show how much capital gains tax you will have to pay.

Long Term Capital Gains Tax Rates in 2020

Single Filers:

Married, Filing Jointly:

Head of the Household:

Married, Filing Separately:

Feel free to bookmark or save this page so you can always have the US tax brackets on hand. Looking at these charts we see that you are able to pay ZERO PERCENT in capital gains tax if you fell into the lowest income range just because we held on to them for longer than 1 year. 😲

But what if you needed to sell a stock in less than a year?

Our tax rates chart would just convert to the normal income tax rates in the US. In our example, you bought 100 shares of ABC and paid 15% in long-terms capital gains tax because we sold in after one year. When selling under one year and paying short-term capital gains tax, we use the US's marginal tax rate system. Let's check out the rates and then dive into how they work.

Single Filers:

Married, Filing Jointly:

Head of the Household:

Married, Filing Separately:

The US tax system is marginal. It's best to explain what this means through an example. If you were a single filer who earned $50,000, the first $9,875 you earned is taxed at 10%, the first bracket. Then, the next bracket is taxed. For us, the next amount of income, between $9,876 and $40,125 is taxed at 12%. Then, because you earned $50,000 this year, you income stops in the third bracket, $40,126 - $85,525. So the remaining amount of income you have left to tax, $50,000 - $40,126 = $9,874 is taxed at 22%. If you earned more money, say $100,000, you would keep going up to the 4th bracket. The more you earn, the higher you climb. This is so that high-earners end up paying a greater percentage of their income to taxes as they earn more.

Stay tuned for a more in-depth article that breaks down the US tax system soon. 👀

Back to stocks, we can see that we are paying significantly more in taxes with short-term as opposed to long-term. The government incentivizes us to invest for longer (which usually ends up making high returns anyways), so they let us pay less taxes. 👏

How Can You Figure Your Capital Gains Tax

A lot of individuals mostly calculate their taxes with the help of software, which makes all the computations automatically. Moreover, you can get a rough idea by using a capital gain calculator. You can use free online tax calculators like this one!

Methods to Avoid or Minimize Tax on Capital Gains:

Long Term Investment:

One of the best ways to minimize the capital gains tax is to invest in stocks for longer periods. Now, if you are a stock trader who trades stocks in the short term, this won’t be for you. However, if you are holding long term investments and betting that a company or index will grow over the course of time; then you are already taking the first step to save money on your taxes.

Set-off Your Capital Losses with Your Capital Gains

Another option you can use to minimize capital gains tax is the setting of your capital losses with capital gains. Suppose you owned stocks in two different companies and you sold them in the same tax year. Now, if you suffered losses on the sale of one stock and earned a profit on another stock, you can set off the losses with profit from another stock. Basically, the IRS will be looking at your “net” or “total” profit. If you made $3,000 on one stock, and lost $1,000 on another, you made a net profit of $2000. Therefore, you would pay taxes on that $2,000.

However, if the capital losses exceed that year’s capital gains, you can set off your losses with your ordinary income. So if you lost a net of $1,000 across all your stocks, then you would claim that loss on your tax return. Therefore, if you earned $100,000, then you would subtract the loss of $1,000 and pay taxes on $99,000. If you are interested in learning more, we’ll post our own walk-through in the near future, in the meantime, check out this article.

As tax day approaches on April 15th, it's always best to consult a tax professional in case you have any questions. However, we will be pushing out more tax content as we approach everyone's "favorite day". Make sure you don't miss anything by signing up for our email updates.

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