Short-Term vs. Long-Term Capital Gains

Short-Term vs. Long-Term Capital Gains

Capital gains can be one of the most overlooked investment tax traps in retirement. This is something that I have seen, we have seen, many times throughout working with retirees and really just understanding what are capital gains, how they are taxed, and how can they work in retirement.

What is a Capital Gain?

So first, let’s talk about what is a capital gain. Capital gain simply put is when you buy an investment and it grows over time and then you sell it. So that profit that you make on an investment is the capital gains income. Now, there are only certain assets that are considered capital gains. So things like an investment property, selling of a stock or a mutual fund within a non-retirement account, or even the sale of a business can count as a capital gain.

So understanding what type of investment you have, if it does qualify for capital gains, is an important part. But let’s say you buy an investment like a stock, like Apple, for example, for $100 and it grows over time and it is now $300. The difference between those two, the $200, it would be considered the capital gain if you were to sell that investment. Then that $200 is reported on your taxes and then it’s taxed from there.

But, another part of capital gains that is important to note is that capital gains are broken down into two categories. They can be either short-term capital gains or long-term capital gains. And what really determines that is simply how long you’ve held the investment.

So, for example, let’s say you buy an investment and sell it within a year. That will be considered a short-term capital gain. If you have held it and sold it for longer than 12 months, longer than a year, then that would be considered long-term capital gains. So, understanding not only what type of investment you have and how long you’ve held it, actually creates a lot of planning opportunities when it comes to taxes.

How are Capital Gains Taxes?

Which leads me to kind of the last part of this, which is how are capital gains taxed? So as you can see, short-term capital gains are taxed as ordinary income, which just simply means it’s taxed like your other income that you get from either a job or pensions sometimes. It’s just taxes, ordinary income. So depending on how much income you have, you can see it will determine at what tax rate that is taxed at, which is typically higher than what long-term capital gains tax rates are.

So how are long-term capital gains taxed? Compared to the ordinary income tax rates, they are pretty simple. They’re either taxed 0%, 15%, or 20%. But they are dependent on your other combined income, things like your Social Security, your pensions, or even W-2 wages as well. That’s what determines which rate they’re taxed at.

So, for example, let’s say you’re a single filer. If you have income less than $40,400 combined between your Social Security, your wages, and all of that, then your long-term capital gains are taxed at 0%. Which you can see can present a huge opportunity to sell investments with zero tax impact. If that single individuals combined income is between $40,400 and $445,850, long-term capital gains are taxed at 15%. And if their combined income is greater than $445,850, then long-term capital gains are taxed at 20%. The same principle applies if you are married filing a joint return, but the numbers may be a little bit different. So if your combined income is less than $80,800, long-term capital gains are taxed 0%. Between $80,800 and $501,600, that’s taxed at 15%. And combined income above $501,601 is taxed at 20%.

Conclusion

So as you can see, understanding how capital gains work, what they are, and how they are taxed is so important. It’s essential in maximizing a retiree’s investment portfolio and creating a better retirement outcome for them over the course of their retirement.