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Capital Gains Tax

When you invest in stocks, bonds and other capital assets, you also owe capital gains taxes on the profits from the sale of those investments.

Normally, if you sell an asset at a higher price than what you paid, you earn a capital gain. If instead, you sell at a lower price than what you paid, you earn a capital loss.

The amount of capital gain is calculated by subtracting the basis from the price for which you sell the asset. You normally add the transaction costs to buy the asset to your basis.

The period of time that you hold your investment determines whether your capital gain is treated as a long- or short-term gain. The IRS sets the cutoff period at one year. That means that if you hold a capital asset for more than a year (i.e., 366 days), the capital gain you realize on its sale is considered a long-term capital gain. Short-term capital gains are those you earn on sales of one year or less.

Short-term capital gains are taxed just like ordinary income. Long-term capital gains, are taxed at a preferential rate. For all except the 10 and 15 percent tax brackets, the long-term capital gains tax rate is 15% on the sale of stocks, mutual funds and similar investments. Investors in the 10 and 15 percent tax brackets pay a long-term rate of just 5%.

What kinds of income do stocks, bonds and mutual funds generate, and how is this income taxed?

Taxation on stocks
Stocks generate taxable income as dividends and capital gains. Usually, growth stocks don't pay dividends. Instead, investors hope to earn returns from an appreciation in the share price. But income stocks generate regular dividend income. Beginning in 2003, dividends are taxed at the same rate as capital gains.

Taxation on bonds
Bonds are also called fixed-income securities as they often have a fixed coupon rate. So, the interest income that you earn is constant over the bond term. Sell a bond for a higher price than you paid for it - you earn a capital gain. Buy a bond at a discount and hold it to maturity - you earn a capital gain. Buy a bond at a premium and hold it to maturity - you face a capital loss.

Taxation on mutual funds
With mutual funds, taxes are a bit more complicated. That's because mutual funds distribute capital gains and dividends from the portfolio of securities they hold. Distributed short-term capital gains are taxed just like ordinary income and distributed dividends and long-term capital gains are taxed as long-term capital gains. When you sell shares of a mutual fund for a higher price than you paid, you either pay a short- or long-term capital gains tax, depending on how long you held the shares.

Investing has other tax rules related to capital gains, including:
The "wash-sale" rule
The "wash-sale" rule prevents investors from selling a security to lock in a capital loss and then immediately buying it back at a lower price. The IRS prohibits you from using the capital losses to offset capital gains if you buy back the same security within a period of 30 days. To avoid being tripped up by the rule, you may want to buy a different security that has a similar investment objective or similar risk characteristics to the one you sold.

Offsetting capital gains with losses
The IRS is OK with you offsetting your capital gains with capital losses. If your losses exceed your gains, you can offset up to $3,000 of ordinary income annually. If you have a larger amount of capital losses, you can carry them forward on to future years. This is the capital loss carryover rule.

Should I wait a year to sell my stock?
Let�s say, you buy 100 shares at $10 each, and the share price grows at 5% per year, i.e., the share price in a year is $10.50. As you have 100 shares, the amount of your capital gain is $50 (transaction fees ignored).

If you are in the 25% tax bracket and sell 365 days later, you pay $12.50 in income taxes. If you wait for an additional day, you pay $7.50 in capital gains taxes.

How does this affect your rate of return? Your net profit on the sale is $37.50 ($50 minus $12.50) in the first case. Your rate of return is 3.75% ($37.50 divided by your original investment of $1,000). In the second case, your net profit is $42.50. This gives you a rate of return of 4.25%, an extra 50 basis points for waiting just one additional day.