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Nov 04 2023
For most investors, seeing profits on their brokerage accounts is enough to make them happy, but many forget or fully understand the tax implications of selling stock at a profit. In my opinion, it's more important to know the tax structure before starting to invest, so that you are in the best position possible to meet your investment goals.
To illustrate this a bit more, say you have invested an intial $200,000 into a portfolio of stocks, ETFs and mutual funds about 8 years ago with a goal of hitting a $1,000,000 in ten years. The market has been good to you and since your initial investment, your portfolio has reached $950,000. In the coming months you believe your portfolio will reach $1,000,000 and you can buy the home of your dreams. But do you really get all of that money tax free? The answer is no and this is due to capital gains tax.
A capital gain occurs when you sell an asset for more than what you paid for. So, say you buy stock A for $20 on Monday. You hold the stock for a week and sell that same stock for $21.50. This is in fact a capital gain, since the stock (the asset), was sold for more than you paid for it (a profit of $1.50). For my math lovers out there, capital gains can be simplified to the following equation:
Capital Gain = Selling Price - Purchase Price
Similar to how the US government wants a cut of your income, they also want to take some off the top when you make a profit on an investment, which is known as the capital gains tax. But say you don't sell the stock at $21.50 in the example above, do you still get taxed even though the stock has risen to a price more than you paid for?
The answer is no, because in this scenario, this gain is unrealized. An unrealized gain is a rise in value for an investment that has yet to be sold. A realized gain on the other hand is selling an investment at a profit, which is capital gain taxable.
The US government outlines different tax rates for the time an investor holds on to an investment. There are short-term and long-term capital gain classifications. Short-term capital gains, are assets that have been liquidated for profit before holding onto the asset for a year and are taxed at a higher rate than long-term capital gains. Gains of this type, are taxed at your regular income tax. By contrast, long term capital gains are taxed at lower rates usually somewhere between 0% and 20%.
Wow. That is a lot of info, is there more to this capital gains tax? Yes, there is…
There is something called net investment income tax, which is an additional percentage on your investment income, which will not be covered in this article.
So how can I minimize capital gains as much as possible?
My answer to this question is simple. Invest long term, especially if you already are bucketed into a higher tax bracket. Short term capital gains can really hurt your money. It's better to leave your money in the market and avoid any hit to your money. When it comes to tax season, you can usually use accounting software to ease the pain of reporting capital gains tax. But when in doubt, hire a professional so that you don't have to deal with any extra paperwork outside of filing your taxes.