When you purchase an asset, hold it for some time, and then sell it, you will incur a capital gain if you make any profit. The taxes associated with these capital gains can strike fear into the hearts of investors, but there is context and strategy to consider when rationalizing that fear. Below are some ideas for better understanding capital gains and methods for managing them within your nonqualified accounts.
Nonqualified accounts are those investments that do not allow for tax deferral or exemption provisions. Brokerage accounts are an example of a nonqualified account. A qualified account allows for tax deferred contributions (pre-tax dollars) but requires you pay tax on the distributions. Examples of qualified accounts are 401k’s and 403b’s. Now that we are clear on the definitions, let’s dive into some details.
In short, yes. Remember that capital gains taxes apply to the “gain”; if you are paying them, it means you’ve made money. Purchase a stock in a taxable account for $50, sell it for $75, and pay capital gains taxes on the $25 profit. The reverse can also be true and is called a capital loss. These, too, have benefits as we can use them to offset some gains elsewhere and even “carry forward” some of those losses in anticipation of future gains.
It is possible never to realize capital gains; some long-term investors do just that. As mentioned, capital gains are realized when you sell the asset, so if you never sell, there is appreciation without tax implications. Another way to delay and minimize capital gains taxes is what is called a “Step Up Provision.” This allows certain assets that are passed onto beneficiaries to have their cost-basis revalued (stepped up) to current-day values, thereby reducing the capital gains implications.
Long-term capital gains tax rates are often lower than ordinary income tax rates. Long-term capital gains are taxed at zero, 15, and 20 percent, depending on the investor’s total taxable income. That compares to the highest ordinary tax rate of 37 percent for 20241. In this way, long-term capital gains are highly advantageous compared to ordinary income. Short-term capital gains, those assets held for less than a year, are considered income in the year they are sold, and are taxed as such. This should be considered when planning your overall tax burden.
1. Haegele, B. (2024, February 28). Capital Gains and Investment Income: How they Differ. Retrieved March 8, 2024, from https://www.bankrate.com/investing/capital-gains-vs-investment-income/
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