When you sell an investment for more than you paid, the profit is a capital gain, and it is taxed differently from your paycheck. Understanding the difference is worth real money, because a single rule, how long you held the asset, can cut the tax rate by half or more.
Here is how capital gains work and the straightforward ways to owe less on them.
Long-term vs. short-term
The key line is one year. Sell an asset you held more than a year and the profit is a long-term capital gain, taxed at favorable rates of 0, 15, or 20 percent for most people. Sell one you held a year or less and it is a short-term gain, taxed as ordinary income at your regular rate, which is usually higher.
That difference is why simply holding an investment a year and a day, rather than selling at eleven months, can meaningfully lower the tax on the same profit.
What determines your rate
Long-term rates depend on your taxable income. Lower-income taxpayers can pay 0 percent on long-term gains; most middle-income taxpayers pay 15 percent; and high earners pay 20 percent, plus a possible additional net investment income tax. Gains inside tax-advantaged accounts like a 401(k) or IRA are not taxed as you sell, only, for traditional accounts, when you withdraw.
Selling losing investments to offset gains, called tax-loss harvesting, lowers your taxable gain dollar for dollar, and up to $3,000 of net losses can offset ordinary income each year, with the rest carried forward.
Simple ways to lower the tax
Beyond holding for the long term and harvesting losses, a few moves help: hold investments in tax-advantaged accounts where they grow untaxed, give appreciated assets to charity instead of cash to skip the gain entirely, and be mindful of your income in the year you sell, since a lower-income year can drop you into a lower gains bracket. And your primary home gets a special exclusion of up to $250,000 of gain (or $500,000 for a couple).
Estimate the tax on a sale above, and remember that the goal is to keep more of your gains, not to avoid ever taking one.
Frequently asked questions
How are capital gains taxed?
Profits on investments held over a year get long-term rates of 0, 15, or 20 percent for most people. Held a year or less, gains are short-term and taxed as ordinary income at your regular rate.
What is the difference between long-term and short-term capital gains?
Long-term gains come from assets held more than a year and enjoy lower rates; short-term gains come from assets held a year or less and are taxed as ordinary income. Holding longer usually lowers the tax.
How can I reduce capital gains tax?
Hold investments over a year, harvest losses to offset gains, use tax-advantaged accounts, donate appreciated assets, and mind your income in the year you sell. A primary home also gets a large gain exclusion.
Do I pay capital gains tax in my 401(k) or IRA?
No, not as you buy and sell inside the account. Traditional accounts are taxed as ordinary income when you withdraw; qualified Roth withdrawals are tax-free.
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