February 24, 2023
Everyone wants to make money. That’s one of the reasons you became a retail shareholder in the first place, right? When you start making money investing, you need to remember capital gains.
Simply put, capital gains are profits earned from an investment. You earn these profits when you sell your investments for more than the amount you originally paid for it. This is called “realized” capital gains. The buying price, or the price that you originally purchased the stock, is called the cost basis and is adjusted for distributions and dividends. Unrealized capital gains are the gains that exist on paper, but have not been made through a sale – yet.
This example from Smartasset illustrates this well: “Say you purchase 100 shares of stock at $10 each, for a total investment of $1,000. You then sell those same 100 shares for $50 each, putting $5,000 in your pocket. Your capital gain represents the difference between what you made and what you paid, or $5,000 – $1,000 = $4,000.”
Earning capital gains is an indication that your investments are producing or that your timing was on point for buying and selling them. And if your gains have been paying well, you may want to be more strategic, depending on your timeline. Individual investors that keep a watchful eye and have patience, can positively impact their portfolios.
If you have received capital gains, they are classified as either short term or long term. Gains earned from an investment that you’ve sold but have held for less than one year is called a “short-term” capital gain. Whereas earnings on funds you’ve sold after holding them for more than one year is called a long-term capital gain. The tax rate for short term gains is the same as your ordinary income tax rate. Put simply, these gains are taxed the same as the money earned from your employment.
Comparably, the long term capital gains tax rate is more advantageous to the retail shareholder ranging from 0%, 15% and 20%. These rates are dependent on your filing status and household income. This advantage exists to reward and entice long-term investing, and create more stability in the financial markets and in the prices of individual stocks.
Both short and long-term gains must be claimed on your annual tax return, and speaking to an investment expert is advisable to help you to determine the best decision given your tax bracket and situation.
As an individual investor whose primary focus is to build wealth, understanding how capital gains tax rates will impact your profit is essential. A consistent rule when investing money is to always understand how it could be taxed. Asking your tax preparer or investment professional for guidance is a good idea, because in certain circumstances capital losses can be deducted from one’s total tax bill, but is dependent on the specifics of the situation.
An attractive way to avoid taxes on capital gains is to focus on tax advantaged accounts like a 401K, IRA or Roth IRA. In these accounts, investments can continue to grow without being diminished by tax payments, generating even more growth. If you have the flexibility to hold these investments undisturbed for the long term, and you can choose to take the profits incrementally, it will reduce your tax liability — especially if you are retired and are in a lower tax bracket due to a smaller income. The tax rate on the gains from someone in that situation will be either very low or zero.
An important distinction is that stock dividends are different than capital gains. A share of earnings paid to current shareholders, dividends are paid at consistent intervals, if a company pays a dividend. Applicable in instances where you own either individual stocks, or a fund, these may distribute dividends directly to you. In contrast, capital gains earnings are only received from the sale of stocks. Another important distinction is that the profits from the sales of holdings bought and sold by fund managers are called capital gains distributions, and these must be passed on to individual shareholders.
Building wealth through capital gains is an attractive and viable way that makes sense provided you consult experienced resources, have time on your side, and make enjoy watching the market.
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