What is a Capital Gain?
A capital gain is the money you make when you sell something for more than you paid for it. This something is called an asset. An asset can be a lot of different things like stocks, bonds, a house, gold, cryptocurrency, or even a baseball card collection.
When you sell your asset, if you get more money than what you originally spent to buy it, that extra money is your capital gain or profit. If you get less money than what you paid, that’s called a capital loss.
How capital gains work
Let’s say you buy a stock for $100. A year later, the stock price goes up and you sell it for $150. The $50 you made is your capital gain.
Or maybe you buy a house for $200,000. After living in it for a few years, you sell the house for $250,000. The $50,000 you made on the sale is your capital gain.
Short-term vs long-term capital gains
How long you own your asset before selling it matters. This is because the government taxes your capital gains differently based on the “holding period” – the amount of time between when you bought and sold the asset.
If you sell an asset you’ve owned for a year or less, that’s a short-term capital gain. If you sell an asset you’ve owned for more than a year, that’s a long-term capital gain.
In most cases, you’ll pay less in taxes on a long-term capital gain than on a short-term one. The government does this to encourage people to invest their money for longer periods of time.
An example of short-term and long-term
Going back to our stock example:
- You buy a stock for $100 and sell it six months later for $150. The $50 gain is a short-term capital gain.
- Instead, let’s say you buy the stock for $100 and sell it 18 months later for $150. Now that $50 gain is a long-term capital gain.
The amount of gain is the same in both cases. But you’ll likely pay a lower tax rate on the long-term gain.
How much are capital gains taxed?
The tax rate on your capital gains depends on which “tax bracket” you’re in. Tax brackets are based on how much total income you make in a year.
For 2023, the long-term capital gains tax rates are:
- 0% if you’re in the 10% or 12% ordinary income tax brackets
- 15% if you’re in the 22%, 24%, 32%, or 35% tax brackets
- 20% if you’re in the 37% ordinary income tax bracket
Short-term capital gains are taxed at the same rates as your ordinary income, like the money you make from your job.
Keeping track for taxes
When you sell an asset, you need to report the gain or loss on your tax return.
Your “cost basis” is generally what you paid for the asset, including commissions and fees. When you sell, the difference between the cost basis and the sale price is your capital gain or loss.
Brokerages and financial institutions usually send you a form at the end of the year with this information to help you fill out your tax return. You’ll need to report each asset sale and the gain or loss from it.
Why capital gains are important
Capital gains are one way that people can grow their wealth over time. When you invest your money wisely and those investments increase in value, you can make a profit by selling them.
This profit is important because it’s money you’ve made on top of your regular income from your job. It’s a way to put your money to work for you.
Encouraging investment
The lower tax rates on long-term capital gains are meant to encourage people to invest their money for the long haul.
When people invest in things like stocks or real estate, it helps grow the economy. Companies use the money from stock sales to hire workers, build factories, develop new products. People buying houses supports the construction industry and all the jobs tied to it.
By giving a tax break on long-term investments, the government is trying to incentivize this kind of economic growth.
Capital gains and retirement planning
For many people, long-term capital gains are a key part of their retirement strategy.
Let’s say you’ve been investing a portion of your paycheck into a retirement account for many years. As you near retirement, you may start to sell off some of these long-term investments. The capital gains from these sales can help fund your retirement, along with things like Social Security or a pension.
And because these are likely long-term gains, you may pay a lower tax rate on this retirement income than you did on your salary during your working years.
An example retirement scenario
Imagine you’ve been buying stocks in your retirement account for the last 30 years. You initially invested $100,000, and over the years, the value of your stocks has grown to $500,000.
Now you’re retired and you decide to sell $50,000 worth of these stocks each year to supplement your other retirement income. The $40,000 gain on each $50,000 sale (remember, $10,000 of each sale is your original investment) is a long-term capital gain.
If this is your only income for the year, you may not owe any taxes on these gains because you’re in the 0% long-term capital gains tax bracket. This can be a very tax-efficient way to fund your retirement.
