Personal Finance 101: Capital Gains Tax

What Are Capital Gains and How Much Tax Do You Have to Pay?

101A reader wrote in wanting a simple explanation of a very hairy topic: capital gains and capital gains tax. I’m going to take a crack at explaining it in very simple terms, leaving out some of the specific vagaries of the United States tax code.

Whenever you buy something, then sell it for a higher value, you incur capital gains. For example, let’s say you buy a Wii at a store for $250, then sell it on eBay for $300. You’ve just incurred $50 of capital gains.

Under the United States tax code, you are required to pay taxes on capital gains. If you have held the item or asset for less than one year, it is considered a short term capital gain and you pay taxes on it equal to your normal tax rate. However, if you hold it for longer than a year, you are charged 15% tax on that amount (it’s 5% if you’re in the 10% or 15% income tax bracket).

So, let’s say that you’re making enough money so that you’re in the 28% tax bracket. If you bought the Wii and sold it a month later, you are charged short term capital gains tax on that Wii, you have to pay $14 in capital gains tax when you file your taxes. However, if you wait a year and a half after the purchase to sell the Wii, you pay only $7.50 in taxes, a savings of $6.50 on your tax bill.

It is this difference that is one of the big encouragements for long term investment. Let’s say you buy $5,000 worth of a particular stock and within six months it doubles in value. If you sell immediately (and are in the 28% tax bracket), you’re going to pay $1,400 in capital gains tax. But if you hold onto it for another six months (and it doesn’t go down), you can then sell it and incur long term capital gains tax, paying only $750. That’s $650 in savings in your tax bill.

Another note: before you figure up your final tax bill at the end of the year, you can subtract your capital losses from your capital gains. So, let’s say you bought $5,000 worth of stock and then sold it later for $4,000 – that $1,000 is considered a capital loss and is subtracted from the gain (short term losses are subtracted from short term gains and long term losses are subtracted from long term gains). This is why many people time the selling of their bad stocks to maximize their tax benefit – they may want to sell it in a particular calendar year, or hold onto it for a full year until it becomes a long-term capital loss.

What’s the story here? Uncle Sam tries to make it worthwhile for people to invest for the long term by giving people better tax rates if they do so. For investors, the “buy and hold” strategy has significant tax benefits over rapid trading of stocks.