|Taxing Capital Gains|
Capital gain fundamentals
You determine a capital gain or loss by calculating the difference between the amounts you paid (basis) plus fees and sales charges, to the sales price plus fees for each security. Taxes on these gains can have a significant impact on how much money you ultimately receive. There are two types of capital gains: short-term and long-term. Short term gains/losses are computed on assets held for less than a year. Long-term gains occur when you hold assets for more than a year.
Just as you are required to pay federal taxes on your income, you will also have to pay taxes on your capital gains. The laws can become complex. You may also be subject to state and local taxation as well.
Tax law is designed to favor long term investments, and thus, you will be taxed less on long term gains than short term ones. To be considered a long-term gain, you must keep the security for at least one day longer than the one year anniversary – or 366-367 days (367 days in a leap year). Holding periods start on the day after you purchase the investment, and they are counted until you sell it. If you buy a stock on March 1st, the first day starts on March 2nd, and you will have to hold the security until at least March 2nd of the following year to qualify. If the stock is sold before that time, it is considered short-term.
There are several possible rates, though in most cases a 15% rate to all investors. The exception for the rate is for those investors in the 10% or 15% brackets, who only pay a 5% capital gains tax and in 2008, the lowest capital gains tax will drop to zero for taxpayers in lower tax brackets.
Short-term capital gains tax rates are equivalent to your highest tax bracket rate. That means that you can owe 35% of your gains in Federal income taxes if you are in the highest bracket. As you can imagine, this cuts significantly into your potential profits. Of course you can offset capital gains with capital losses plus up to an additional $3,000 if your capital losses exceed your gains.
Strategies to minimize your taxes
Before investing, evaluate your risk tolerance and timeline of the particular investment. Taxes are a fact of life and typically are not considered when making investment decisions although they often influence the timing of the sale of a particular investment.
A simple strategy is to keep your stocks until they qualify for long-term holding rates. This will help keep you at a lower tax rate, particularly if you are in the higher tax brackets.
You can also consider selling investments that are not performing and will result short term losses. Losses will help offset your tax burden, allowing you to pay less in taxes. Adopting a “highest cost in, first out” mentality when deciding which securities to sell will help you lower the amount of capital gains and increase reportable losses.
Lastly, you will want to be aware of the wash sale rule. You cannot reap the benefits of deducting capital losses if you claim a loss on a security, but then repurchase the same stock within 30 days after the sale. You cannot buy the stock for at least 31 days in order to claim the loss.
By planning ahead, and possibly working with your tax advisor, you can implement strategies that are beneficial for your portfolio and your true profits.