PC: The Balance
Whether you realize it or not, you pay taxes on your capital gains. However, the rate at which you do this differs depending on your tax bracket.
The stock market had a difficult January, but if you’ve been investing for a while, you’ve probably made significant substantial gains during the past few years. Numerous forecasts for the remainder of 2022 indicate potentially promising stock market gains. Gaining money from your stock market assets is fantastic, but you should be aware of the capital gains taxes you may be subject to when purchasing and selling your shares.
The amount of capital gains taxes you ultimately owe on the earnings from your investments will largely be determined by three variables.
1) How much your investments have grown in value
2) The length of time you’ve kept your investments
3) The sum of all of your earnings.
Your net profit is taxed as either a long-term or short-term capital gain at the federal level when you sell an investment (stocks, bonds, mutual funds, ETFs, real estate, cryptocurrency) for more than your cost basis (basically, what you paid for the transaction). Your state-specific capital gains tax liability will be determined at the state level. For instance, California taxes capital gains similarly to regular income, with a top state tax rate of 13.3%. OUCH!
Your gains will either be taxed at long-term capital gains rates or short-term capital gains rates depending on how long you owned the investment. Long-term capital gains rates apply if you have owned your investment for longer than a year. Your capital gains will be taxed at the short-term capital gains rates for investments held for less than a year.
Let’s examine how federal taxation of long-term capital gains truly works. Generally speaking, long-term capital gains will have more advantageous tax treatment than short-term capital gains. Depending on your taxable income and marital status, long-term capital gains are taxed at a rate of 0%, 15%, or 20%.
If your income is less than $41,675 in 2022, you can benefit from the zero percent capital gains rate as a single taxpayer. The 15% capital gains rate, which is applicable to incomes between $41,675 and $459,750, will be applied to the majority of single people with investments. For single filers with incomes over $459,750, the long-term capital gains rate will be 20%.
The brackets are slightly larger for married couples who file jointly, but the majority will see the marriage tax penalty applied to their investment income. The good news is that married couples with earnings of $83,350 or less continue to be taxed at 0%. You have to appreciate tax-free income. The capital gains tax rate for married couples earning between $83,350 and $517,200 is 15%. Those with incomes over $517,200 will be subject to a long-term capital gains rate of 20%.
Medicare Surtax on Income from Capital Gains
For those with higher earnings, there can be additional taxes on investment income or lost tax deductions. For instance, a 3.8% net-investment surtax will also be applied to married taxpayers with incomes over $250,000. For single filers, the Medicare surtax is applicable on incomes over $200,000. Regardless of whether the capital gains are long-term or short-term, this Medicare surtax is applied to all investment income. Since this threshold is not indexed for inflation, more taxpayers should anticipate paying the Net Investment Income Tax each year (NIIT).
Rates for Short-Term Capital Gains in 2022
Short-term capital gains are normally taxed at ordinary income rates when they are realised. Any gains or losses on the sale of an investment held for less than a year will be classified as short-term capital gains or short-term losses, respectively. The good news is that short-term losses up to $3,000 can be written off against normal income annually. That offers a fantastic opportunity to use tax-loss harvesting to reduce your taxes.
Harvesting Tax Losses Can Help You Pay Less Tax
Not all investments have witnessed significant value rises, despite the recent boom in the stock market. This is particularly valid in light of the recent volatility we have experienced in 2022. I frequently take on new clients whose previous financial advisors seemed to have had a golden knack for selecting awful investments and poor market timing (perhaps in part because they were the previous financial advisor).
Positively, this gave them some chances to use tax-loss harvesting to lower the taxes owed on their regular income. They used the more than $3,000 in short-term capital losses that we were able to seize to balance their regular revenue. Similar to this, we were able to balance some of the other investment losses with investment profits from their employee equity pay.
Retirement account taxes on investment gains
Gains will be tax-deferred in your 403(b), 401(k), traditional IRA, Defined-Benefit Pension Plan, and tax-sheltered annuities (TSA). Until you take a withdrawal, you won’t have to pay taxes on the profits in your retirement funds. If you follow Internal Revenue Service (IRS) guidelines, your withdrawal from a Roth 401(k) or Roth IRA will be tax-free.
Taxation of Real Estate Capital Gains
When you sell real estate, particularly your primary residence, there are some tax benefits. You might be able to avoid paying a sizable amount of taxes on your gains when you sell your principal house. When you sell your principal residence, you might not be required to pay any capital gains taxes in many areas of the nation.
If they sell their primary dwelling, homeowners who are single (i.e., not married) may be entitled to exclude up to $250,000 in capital gains. In the case of a married couple selling their primary house, this amount doubles to $500,000 instead. There are a few requirements you must meet in order to qualify for this significant tax reduction, chief among them being that you have to dwell in your principal property for at least two of the previous five years.
Remember that the taxable gain is determined by your home’s cost basis, which could differ from the amount you paid for it when you first bought it. Therefore, be careful to keep track of all the home renovation or improvement projects you have funded throughout the years. A new water heater or roof, for example, can raise your home’s cost basis. Your tax burden when you eventually sell your house will be reduced the greater your cost basis is. For instance, if you pay $5 million for a McMansion in West Hollywood and spend $1 million refurbishing it, your cost basis will be $6 million.You could sell it for $6.5 million if you were married and had lived there for two of the previous five years without having to pay capital gains taxes on the transaction.
For properties used as investments, the rules are a little bit different. In addition to the net profit from the sale, you will also be responsible for paying capital gains taxes on the cumulative depreciation benefits you earned while owning the property. Depreciation recapture is the term for that procedure. The subject is too complex to be covered in full here. Just be aware that with investment properties, your cost basis is probably lower than the money you invested in it. Before selling your investment property, discuss the tax ramifications with your certified financial advisor and CPA to make sure you understand them. A 1031 exchange may allow you to postpone taxation if you are selling one property and buying another.
Should You Steer Clear of Quick Capital Gains?
When choosing whether to acquire or sell investments, taxes should be the sole factor considered. However, you should be conscious of how long you’ve held the investment and the taxes that will apply to its sale. You should frequently strive to prevent being smacked with short-term capital gains, especially if you have owned the investment for nearly a year. Long-term investing or retaining an investment for at least a year are encouraged by the IRS tax code. The rates on long-term capital gains will typically be lower than the rates on your earned income.
Your net after-tax investment returns may go up if you can lower the tax impact on your investment. To make sure you are investing in the most tax-efficient way possible and avoiding paying extra taxes, consult your financial adviser and CPA.