By Lee Sherman
An understanding of how capital gains can affect your portfolio is essential for any investor. Put simply, a capital gain is the profit you’ve earned on the sale of an asset which has increased in value over the holding period. Capital gains aren’t limited to stocks, bonds, and mutual funds but apply also to anything that can be considered an investment. This includes art, wine, coins, stamps, baseball cards and other collectibles.
You can also suffer a capital loss, which, as you might expect, occurs when the purchase price of an asset exceeds the sale price and any losses in your portfolio can be used to offset your capital gains. The most important thing to remember is that, while your goal as an investor should be to continue to turn a profit, the taxes you’ll pay can cut heavily into those profits. In theory, you have little to worry about since you’ll only be taxed on any profit you make from an investment but unlike other kinds of taxes, the capital gains tax can be levied on any individuals (not just businesses) who acquire wealth through investing.
How Capital Gains are taxed
The most common formula for calculating a capital gain and determining how much tax you’ll owe is to take the sale price of an asset and subtract how much it cost along with any incurred expenses. For example, if you bought a vacation home for $100,000 and sold it for $150,000, you’d report a capital gain of $50,000. How much tax you’ll actually pay is dependent on how long you’ve held the asset, in this case your vacation home, and on your income. Capital gains can be either short term or long term. Short term capital gains occur when the asset is held for less than a year and long-term capital gains occur when the asset is held for over a year. Assets that are held for less than a year are taxed at the same rate as your normal income, while those held longer will be taxed at a long-term rate, which is currently 15% for most people. It is 20% for individuals who make more than $425,800 and zero if you earn less than $38,600.
How to avoid Capital Gains taxes
By investing in certain kinds of retirement plans, you can limit your exposure to capital gains taxes. A Roth Individual Retirement Plan lets you invest up to $6,000 annually without any tax liability but you can’t withdraw the money until age 59 1/2. A 529 College Savings Plan is also exempt from capital gains taxes so long as the money is used for its intended purpose. For more information on these plans, consult the Internal Revenue Service (IRS) website or check with your financial planner.
Lee Sherman is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Lee is an experienced journalist and editor with over 30 years of expertise with a significant history of writing in the personal finance and technology arenas.