In this overview, we’ll look at how your investments are taxed and strategies to help minimize the taxes you pay on those earnings.
When it comes to your investments, you may spend considerable time choosing the best strategies, as well as the tax consequences on those investments.
What are Capital Gains?
Capital gains and losses arise from the sale of a capital asset, and the applicable tax rate depends on how long the capital asset was held as well as your income. Generally speaking, long-term capital gains/losses are from the sale of capital assets held for more than a year, while short-term capital gains/losses are from capital assets held for a year or less. When the capital asset is sold for more than what was invested in it, the difference is a capital gain, which is subject to taxes.
Taxes on Capital Gains
Long-term capital gains generally qualify for a tax rate of 0%, 15%, or 20%. Under the Tax Cuts and Jobs Act of 2017, long-term capital gains tax rates are applied to income levels that differ from regular income tax brackets, as shown in the table below. Short-term capital gains are still taxed at your ordinary income tax rate.
| Long-term Capital Gains Tax Rate | Income: Single Filer | Income: Married Filing Jointly |
|---|---|---|
| 0% | 2023: Up to $44,625 2024: Up to $47,025 | 2023: Up to $89,250 2024: Up to $94,050 |
| 15% | 2023: $44,626 to $492,300 2024: $47,026 to $518,900 | 2023: $89,251 to $553,850 2024: $94,051 to $583,750 |
| 20% | 2023: Over $492,300 2024: Over $518,900 | 2023: Over $553,850 2024: Over $583,750 |
3.8% Net Investment Income Tax Triggers
Those at the higher end of the income spectrum will need to account for a surtax in their capital gains income. The Health Care and Education Reconciliation Act of 2010 brought with it a 3.8% Medicare surtax on net investment income for taxpayers with modified adjusted gross income (MAGI) over a certain threshold. Net investment income includes interest; dividends; capital gains (including gains from investment real estate); rental and royalty income; income from financial instrument or commodity trading; and income from businesses that generally do not require active involvement from the taxpayer.
The statutory threshold amount for a tax year depends on your filing status, and these amounts are not indexed for inflation:
| Filing Status | Threshold |
|---|---|
| Married Filing Jointly, Qualifying Widow(er) | $250,000 |
| Single, Head of Household | $200,000 |
| Married Filing Separately | $125,000 |
If your MAGI is above the applicable threshold, the 3.8% tax will be applied to the lesser of your total net investment income or the amount by which your MAGI exceeds the threshold.
Take, for example, a single filer whose MAGI is $240,000, of which $180,000 is wages and $60,000 is net investment income. With MAGI $40,000 over the surtax threshold and net investment income of $60,000, he’ll pay the 3.8% surtax on $40,000, which is the lesser of the two, resulting in a net investment income tax of $1,520.
Capital Gains Taxes – Examples
Frequent changes in your investment holdings can result in tax payments on capital gains – especially in tax-inefficient asset classes like REITS, commodities, bonds, and small/mid-cap funds.1 In the examples below, we illustrate the impact of both long-term and short-term capital gains taxes on a hypothetical stock. Assume for these examples that the sale of stock is the only investment income. We also show the impact across several income tax brackets for a married couple filing jointly. As you can see, capital gains taxes can add up quickly.
| Long-term Example (Married Couple) | MAGI: $150,000 15% Capital Gains Rate | MAGI: $300,000 15% Capital Gains Rate | MAGI: $600,000 20% Capital Gains Rate |
|---|---|---|---|
| Purchase 500 shares at $100 each | $50,000 | $50,000 | $50,000 |
| Sell 500 shares at $200 each more than a year later | $100,000 | $100,000 | $100,000 |
| Net investment income | $50,000 | $50,000 | $50,000 |
| Taxes owed on capital gains | $7,500 | $7,500 | $10,000 |
| Net investment income tax owed | $0 | $1,900 (3.8% on $50,000) | $1,900 (3.8% on $50,000) |
| Total capital gains tax obligation | $7,500 | $9,400 | $11,900 |
| Short-term Example (Married Couple) | MAGI: $150,000 22% Marginal Tax Rate | MAGI: $300,000 24% Marginal Tax Rate | MAGI: $500,000 35% Marginal Tax Rate |
|---|---|---|---|
| Purchase 500 shares at $100 each | $50,000 | $50,000 | $50,000 |
| Sell 500 shares at $200 each less than a year later | $100,000 | $100,000 | $100,000 |
| Net investment income | $50,000 | $50,000 | $50,000 |
| Taxes owed on capital gains | $11,000 | $12,000 | $17,500 |
| Net investment income tax owed | $0 | $1,900 (3.8% on $50,000) | $1,900 (3.8% on $50,000) |
| Total capital gains tax obligation | $11,000 | $13,900 | $19,400 |
Strategies to Help Avoid Capital Gains Taxes
There are a number of strategies to consider when seeking to control the loss in your portfolio caused by the taxation of capital gains. Below are four popular options to optimize your investment growth:
1. Long-term investing — Holding assets for the long term ensures you pay only the tax rates applicable to long-term capital gains tax, which are less than the rates for short-term capital gains. Keep in mind that many factors impact your investment decisions and there are any number of reasons you may want to sell earlier than you plan.
2. Using capital losses to offset gains (tax-loss harvesting) — This strategy requires losses in order to offset your gains. For example, if you are invested equally in two stocks and one company’s stock rises by 20% and the other company's falls by 10%, you can subtract the loss from the gain, reducing the amount of capital gain on which you pay tax. Keep in mind that there is a cap on the amount of capital loss you are able to use against your capital gain, and the losses needed for this approach are real economic losses to you.
3. Retirement plans — There are numerous types of qualified retirement plans like the 401(k), 403(b), IRA, and Roth IRA, where your investment can grow tax deferred. Most of these plans don’t require participants to pay income taxes until funds are withdrawn from the plan. Typically at retirement, many investors may find themselves in a lower tax bracket than during their working years.
4. Annuities — Similar to qualified retirement plans, annuities grow without being subject to capital gains taxes and aren’t taxed until funds are withdrawn (annuity withdrawals are taxed at ordinary income tax rates, not at capital gains tax rates).2 The main differences are in how the money paid into the annuity is taxed prior to being paid in and how much can be paid in. In qualified annuities, you pay in pre-tax dollars. In a non-qualified annuity, you use after-tax dollars. Consider a non-qualified annuity once your qualified plans are maxed out or when you have a windfall to use for additional retirement savings.
The Bottom Line
Capital gains are a result of investments that have performed well, but taxes can eat away at their compounding power. You have a range of strategies to help you mitigate such losses – from buy and hold, tax-loss harvesting, maxing out your qualified retirement plans, and contributing to tax-deferred annuities.
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1Generally, tax-inefficient asset classes are asset classes such as alternatives, bonds, real estate, and utilities, as well as other funds that may generate ordinary income, dividends, or short-term capital gains when they are purchased outside of a tax-deferred investment vehicle.
2Withdrawals from an annuity are taxable as ordinary income and, if made before age 59½, may be subject to a 10% IRS penalty tax. Investing in an annuity through a tax-qualified contract, such as an IRA, offers no additional tax benefit.