While inadvertent, this will mark the third entry in what has become a series of tax related articles. This article will build off my previous entry, about how taxes on stock trades work. To see the article which started the series, click here. Today we’ll take a more in depth look at the different types of capital gains.
Long Term Capital Gains
First, let’s review the basics pertaining to long-term capital gains. Long-term capital gains apply to profits gained from securities that you held for over one year. As of 2022, a single person making up to $41,675 annually would pay 0% in long term capital gains. A person making $41,676 to $459,750 would pay 15%. Anyone making over $459,751 would pay 20% on their long-term capital gains.
Let’s assume that you are a retired investor, whose only source of income is profit taking on long term investments. Allow us to assume that these profits total just under $41,000 per year. In this situation, given that you have no regular income you might think that you owe nothing in taxes. After all, you are in the 0% long-term capital gains bracket. You are partially correct, as you would pay nothing on your long-term capital gains. However, you would still have to pay the 12% federal tax rate. While you may not consider investments as income, they do contribute to your overall gross income. When it comes time to do taxes, you will have to pay federal taxes on your adjusted gross income.
Fortunately, since it counts as gross income, you can also apply deductions to your income. Let’s say that the situation is slightly different, and you are a married investor. You and your spouse file your taxes jointly, making your 0% tax threshold $83,350. But, perhaps your overall long term capital gains total just over $105,000. With the married filing jointly standard deduction of $25,900, your taxable income would fall below $80,000. In this scenario, after applying your standard deduction, your capital gains would fall under the 0% bracket.
Short Term Capital Gains
Short term capital gains work quite differently compared to long term capital gains. In addition, the two types of capital gains are taxed in two distinctly dissimilar ways. Short-term capital gains apply to profits from securities that you hold for less than one year. Assessing short-term capital gains are based on your federal tax bracket. So, whereas long term capital gains had its own bracket structure, short term gains fall under traditional income taxation.
Just focusing on the different tier levels, there are seven tax brackets. For singles income up to $10,275 is 10%. Up to $41,775 is 12%, $89,075 is 22% and $170,050 is 24%. Up to $215,950 is 32%, $539,900 is 35% and anything higher is taxed at 37%. Those married filing separately have the same brackets up until the 35% level. Any income up to $323,925 is taxed at 35%, and anything higher is taxed at 37%. Those filing as head of household have the same tiers as singles for the 24%, 32%, 35% and 37% brackets. Their 10% bracket is up to $14,650, 12% up to $55,900 and 22% up to $89,050. Those married filing jointly have most of their tiers as double that of someone filing as a single. The two exceptions are the 35% and 37% tiers, which end at $647,850 and start at $647,851.
As mentioned in a previous paragraph, there is an additional tax levied for high earners. A 3.8% tax is levied regardless of holding period, though at different income levels. Single or head of household filers would have this tax levied once they made above $200,000. Married filing jointly and qualified widow(ers) when they make above $250,000. Those married filing separately would be assessed the tax after $125,000.
All of this does not take into account special circumstances at the state level, regarding types of capital gains. Some states do not tax capital gains at all, but this represents a small minority of states in the U.S. In general, states levy an additional tax on capital gains. These rates range from 13.3% in California to 2.9% in North Dakota. So even if you are in the 0% tax bracket federally, you still may have to pay state taxes.
In addition, the White House made an announcement yesterday. The president introduced a minimum income tax of 20% as part of the White House’s 2023 budget. The tax would apply to all household worth $100 million dollars or more. In addition, the tax would apply to unrealized capital gains, not just realized gains. Previous efforts at similar legislation have been rejected, so there is no guarantee that the tax will actually be implemented.
Types of Capital Gains: Conclusions
As you may have noticed, the two types of capital gains are assessed taxes very differently. There is definitely a preferential treatment provided to long term capital gains, especially the larger the profit is. When analyzing your investments, gauge if you need to take profits now, or if you need the money for other purposes. If not, holding the investments to get over the one-year threshold may be in your best interests. Whatever you decide, I hope you found the article useful, and feel better prepared to assess your tax status.