What is capital gains on stocks?

 When you own an investment asset, there are usually two ways to earn a return on your investment.  The first is through income payments, such as interest and dividends.  The second is by increasing the value of that asset, which is recognized as a gain - a capital gain - when it is sold.

 With the massive rise in the value of financial assets over the past decade, capital gains are replacing dividends as the primary source of stock returns.  For this reason, let's dive into the technical aspects of capital gains.

 

 What are capital gains on stocks?

 Capital gains are the increase in the value of capital assets.  This asset can be just about anything, but often relates to either real estate or financial assets such as stocks, bonds, and mutual funds.

 As I mentioned above, investments typically produce returns either through fixed income payments, such as interest and dividends, or through capital gains.  Like interest and dividends, capital gains usually result in a taxable event.

 Let's say you buy 100 shares of stock at $50 each, for a total investment of $5,000.  Six months later, the stock price has risen to $65 per share.  You sell your entire position for $6,500, making a profit of $1,500 on the sale.

 The purchase price of $50 per share is your cost basis.  A gain of $1,500 represents a capital gain.

 One important difference with capital gains relates to realized and unrealized gains.  The example shown above represents realized capital gains.  This is because the stock has been bought and sold, and the gains are received.

If the same situation happens, but you did not sell the stock, then the profit will not be realized.  This is sometimes referred to as a paper earning, because it is on paper only and is not received as cash.

 Only the realized capital gain is taxable, because the profits have already been received.

 If your stock position grows from $5,000 to $50,000 over five years but you don't sell the stock, the profit isn't taxed, because the profit isn't actually received yet.

 

 Capital Gains Dividends on Mutual Funds and Exchange Traded Funds (ETFs)

 

 Mutual funds and exchange-traded funds (ETFs) can also generate capital gains if you sell them for more than your initial investment.  But they can also produce a steady stream of capital gains while they own it.

 Each fund represents a portfolio of stocks.  At various times during the year, the fund will sell some shares within the portfolio.  If the shares are sold at higher prices than they were bought for, it will produce capital gains.

 These gains will be transferred to the fund's investors through what is known as a capital gain distribution.

 In USA, at the end of each year, the investment company that owns your fund will issue an IRS Form 1099 to report the results of your investment.  Form 1099-DIV will report both dividends and capital gains dividends generated by the fund.

 The amount of capital gains dividends generated by the fund depends on whether it is a passively managed fund or an actively managed fund.

 Passively managed funds participate in very little stock trading.  The most common example is an index fund.  Since the fund is designed to match the underlying stock index, stocks are only traded when the index changes.  Index funds (usually ETFs) generate very little in the way of capital gains distribution.

 The managed fund is actively trying to outperform the market.  You will buy and sell shares at appropriate times.  Sales will generate more frequent capital gains dividends.  On an actively managed account, these gains can be significant each year.

 If you sell your money outright, and there is a gain from the sale, you will receive Form 1099-B, reporting the proceeds from broker and barter transactions.  (You will also receive this form to report the sale of individual assets held by this broker.)

 

How long to hold inventory for capital gain

 For income tax purposes, there are two types of capital gains: short term and long term.  The tax treatment for each is fundamentally different.

 By definition, a short-term capital gain occurs when a bond or asset is held for one year or less.  If you make short-term capital gains, they will be added to your income and taxed at your usual income tax rate.

 For example, let's say you bought $10,000 of a particular stock in February, and then sold it for $15,000 in November of the same year.  You will receive a capital gain of $5,000.  Since the gain is considered short-lived, it will be taxed at the usual income tax rate.

 If you are in the 22% tax bracket, this is the rate that will apply to your short-term capital gains.  In this case, the tax liability would be $1,100 ($5,000 multiplied by 22%).

 The situation is quite different with long-term capital gains because they are subject to lower income tax rates.  By definition, long-term capital gains are those that are realized after holding an asset for more than one year.  If you sell an asset for a year and a day (or later) after you buy it, it qualifies as a long-term capital gain and is subject to low taxes.

 This feature exists to encourage long-term investment, which creates more stability in financial markets as well as in individual stock prices.

 

 How Much Capital Gains Tax on Stocks?

 As stated above, short-term capital gains are taxed at ordinary income tax rates.  But there is a significant drop in federal income tax rates for long-term capital gains.  This provides a great incentive to hold any investment for more than one year.

How to avoid capital gains tax on stocks

 There are probably at least dozens of ways to avoid capital gains tax on stocks, but we'll focus on the three most common ones.

 

 1. Keep discretionary assets in a tax-protected retirement plan.

 This can include a traditional Roth IRA, 401(k), 403(b), SEP IRA, or SIMPLE IRA.  Since each plan features investment income deferral, any capital gains realized under the plan will not be subject to immediate taxes.  This includes both short-term and long-term capital gains.

 Technically, capital gains tax will not be specifically applied to these transactions.  Money held in a tax-deferred retirement plan does not become taxable until it is withdrawn.  Once this is done, they are taxed at the normal tax rate.  But you will be able to largely control your tax liability by limiting the amount of withdrawals you make from any of these plans.

 

 2. Compensation of capital gains with capital losses.

 The IRS allows you to deduct capital losses from capital gains before calculating the capital gains tax liability.  We will not delve into this discussion as it is covered in a separate article.  But basically, if your investment portfolio generates $20,000 in capital gains, but you also have $12,000 in capital losses, then your taxable net capital gains is only $8,000.

 Balancing capital gains with capital losses is even a formal investment strategy, known as tax loss harvesting.  It is a common practice with robo-advisor investment platforms.

 3. Do not sell your investment.

 Remember earlier we said that capital gains are not taxed until the investment is sold and the profit is made?  If you never sell the asset, it can continue to grow in value without creating a tax liability.  This is a form of back tax deferral, similar to tax-protected retirement plans.

 Of course, this strategy will work best with investments in companies with strong long-term growth and income prospects.  In theory, at least, you could hold the stock for 20 years and watch it grow tenfold in value and never incur capital gains tax.

 But the more traditional way to do this is by using index-based ETFs.  Since the shares in the fund are rarely sold, the ETF can continue to build in value as the years go by.  Later, when you need to withdraw income from the fund, you can begin to receive it in small amounts.  These small withdrawals will also limit capital gains income from selling parts of the ETF.

 This will not only reduce the tax, but also defer liability until the future.  Since selling a portion of an ETF is similar to selling a stock, the sales will benefit from lower long-term capital gains tax rates.

 

Capital gains help you build wealth over time

 Between the growth in the value of a stock or fund you own and the tax benefits of lower long-term capital gains tax rates, it's easy to see why capital gains are one of the most important wealth-building strategies for the average investor.

 The benefits multiply when the capital gain-generating assets are held in tax-protected retirement plans.  There, investments can continue to grow without being reduced by taxes, generating more growth.

 And with tax deferrals for tax-protected retirement plans or funds in the very long run, the tax liability can be deferred almost indefinitely.  And when the day comes when you start making profits, you can do so in very small increments and with a very small tax obligation.

 If you are able to delay these withdrawals until you retire and are supposed to be in a lower tax bracket due to lower income, the final tax rate on these gains will be either very low or even zero.

 Is there any wonder why capital gains have become the primary means of building wealth for the average investor?

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