It’s that time of year, where we have a “holiday” that really only makes tax accountants happy. That is right, tax day is upon us. This is the due date for every person in America to file their taxes by. Usually, this falls on April 15, but the IRS extended the deadline to May 17 for 2020 filings to allow people additional time due to the pandemic.
While taxes can be daunting, there are some great self-service offerings out there such as TurboTax and H&R Block or you can always hire a qualified tax accountant to file for you.
A lot of elements go into filing taxes and each person’s finances are unique. 2020 was a year where retail investors (not investment professionals, but your average joes) made up 19% of the overall market trading volume, an increase of 4% from 2019 and double that of 2010. With this in mind, we want to focus on a specific element of tax filings, capital gains.
What Are Capital Gains?
Capital gains are defined as “an increase in the value of an asset or investment resulting from the price appreciation of the asset or investment.” In layman’s terms, if you bought a stock share for $50 and sold it for $100, your capital gain on that transaction would be $50 ($100 sale price – $50 initial investment). This applies to stocks, real estate, bonds, etc. Capital gains may sound confusing, but as you’ll see, they are actually pretty straightforward.
Why Do We Care About Capital Gains?
Capital gains are important because they could have serious tax implications. Two main factors will help you determine if capital gains matter to you…1) did you sell an asset for a profit and 2) how long did you hold that asset before selling?
Realized vs. Unrealized Gains
Capital gains can be either realized or unrealized, depending on if you sold them or not. A realized gain occurs when you sell an asset at a value greater than what you bought it at. Only realized gains are taxable. An unrealized gain occurs when the asset appreciates in value, but you still own it. For example, if you bought your home at $500K ten years ago and it is now worth $600K, you have an unrealized gain of $100K because the house has grown in value but you have not sold it.
Short-Term Capital Gains
What Are Short-Term Capital Gains?
Short-term capital gains occur when you sell an asset for a profit and you only held that asset for less than one year. A good example of this is day traders in the stock market. Day traders, as their name implies, often buy and sell the same stocks multiple times per day. Given that they may only hold stocks for minutes, they are an extreme example of short-term holdings.
Short-Term Capital Gains Tax Implications
Short-term capital gains carry a disadvantaged tax implication compared to their more friendly cousin, long-term capital gains, because they are taxed as ordinary income. If you need a refresher on how progressive tax brackets work, check out our previous article. In this scenario, if you sold a short-term asset for a gain, dependent on your overall income scenario you will likely get slapped with a higher tax bill for your gains. Also, since it is counted as ordinary income, it could push part of your earnings into a higher progressive tax bracket overall if you are already on the cusp.
Long-Term Capital Gains
What Are Long-Term Capital Gains?
Conversely, long-term capital gains are profits on assets you’ve held for over one year. This scenario often applies to common real estate transactions or investors who buy and hold their stocks for extended periods of time.
Long-Term Capital Gains Tax Implications
Long-term capital gains are taxed at more favorable rates since they are not considered ordinary income. Below are the 2020 rates for long-term capital gains and you will notice they are lower than what most people would pay based on their ordinary income brackets. There are different rules for tax implications on real estate that can be found here.
| Long-Term Capital Gains Tax Rate | Your Income |
| 0% | $0 to $40,000 |
| 15% | $40,001 to $441,450 |
| 20% | $441,451 or more |
Source: NerdWallet
How To Calculate Your Capital Gains Taxes
Hopefully capital gains and their tax implications are pretty clear at this point, but NerdWallet developed a handy dandy capital gains tax calculator to help you determine your tax liabilities.
401Ks and IRAs Are Your Friends
As we outlined in our Beginner’s Guide to Investing, hopefully you are maxing out your retirement accounts to your best ability before putting too much into a normal brokerage account. This is especially helpful when it comes to the tax implications around capital gains. Tax-advantaged accounts, such as traditional and Roth 401Ks and IRAs, don’t incur capital gains taxes making them the perfect vehicle to limit your tax liability. For traditional 401Ks and IRAs, your distributions upon withdrawal will be taxed as ordinary income though. Check out our previous articles to freshen up on IRAs and 401Ks and any tax implications to be aware of.
Happy tax season and remember, if you’re not sure on how to properly file your taxes, reach out to a tax professional.
Check out additional topics to make personal finance SLIGHTLY EDUCATIONAL on our Personal Finance page.
