With a solid investment strategy, it is possible to amass hundreds of thousands of dollars over the years. Capital gains taxes, however, will subtract away from your bottom line and slow the wealth creation process. For relief, it is critical that you learn to distinguish between short-term and long-term capital gains taxes. When plotting investment strategy, you should bear in mind that the tax code is designed to reward long-term investing.
Holding Period and Tax Rates
With a taxable brokerage account, you will owe capital gains taxes when you sell an investment at a profit. For the 2010 tax year, capital gains are classified as either short-term or long-term capital gains. Short-term capital gains are taxed at the ordinary income rates of 10, 15, 25, 28, 33, and 35 percent. Long-term capital gains, however, are either tax free or taxed at maximum 15 percent rates. As a single filer, your long-term capital gains will be tax free if you report less than $34,000 in taxable income. To qualify for long-term capital gains, you must hold an investment for more than one year before selling it off.
Cost Basis and Sales Proceeds
You will attach Schedule D to Form 1040 to report and pay taxes on your capital gains to the IRS. On Schedule D, you will calculate cost basis and sales proceeds, before figuring out your realized capital gains. Cost basis and sales proceeds take your brokerage commissions into account. For example, you may trade stocks through an online broker at ten dollars a trade. In February, you purchased 100 shares of Corporation Z at $50. Your cost basis would then be $5,010 (100 shares x $50 = $5,000 + $10 brokerage commissions = $5,010). Later that year, you sold Corporation Z for $60 a share. Sales proceeds on that transaction would then be $5,990 (100 shares x $60 = $6,000 – $10 brokerage commissions = $5,990). As a result, you would owe short-term capital gains taxes on $980 worth of stock market profits ($5,990 – $5,010 = $980).
Realized Capital Losses
For the 2010 tax year, you can deduct $3,000 worth of realized capital losses. Losses that exceed $3,000 can be carried forward and deducted in subsequent years. Be advised that the IRS prohibits wash sales for the sole purpose of taking a deductible loss. A wash sale occurs when you sell a stock at a loss and immediately buy it back within 30 days.
When investing money, your ultimate goal remains to secure the highest return for the least amount of risk. Balancing risks versus rewards efficiently does not always translate into a minimal tax bill. For example, you should not hold onto a losing stock simply to deduct realized capital losses from your taxable income.
Short-Term Vs. Long-Term Capital Gains Taxes, Sources:
IRS: Capital Gains and Losses
IRS: Ten Important Facts About Capital Gains and Losses
IRS: Investment Income and Expenses
More From Kofi Bofah and Yahoo! Contributor Network:
CD Structure and Laddering
Buying Stocks: Dividend Reinvestment Plans (DRIPs)
How to Pay Off Credit Card Debt Fast