What are Capital Gains Taxes and How Can You Beat Them?

When our insurance clients learn that we at McDowell are also a Registered Investment Advisor (RIA) and that we help clients with their financial planning, we often arrive pretty quickly at the topic of capital gains tax.

It’s no surprise really – capital gains and their subsequent taxation are hot-button issues and ones that keep growing in importance. And there are lots and lots of complexity involved – which often keeps people away from the topic. But we’ve found that those with a cursory knowledge of capital gains have a better chance of navigating its murky waters than those who don’t.

So, since we believe that educating both clients and others is an imperative part of building a better business and overall industry, we’re going to take just a couple of minutes and give you the lowdown on capital gains taxes and why they could be important to you – especially right now.

WHAT ARE CAPITAL GAINS TAXES? 

Let’s say that you, as an investor, buy a stock at $20 a share. Over the span of a year, that stock grows in price to $30 a share. The $10 you made over the year is a capital gain.

There are two kinds of capital gains tax: one incurred if you’ve owned the asset (or bond, or real estate, or mutual fund) less than a year, and a generally less heavy tax on capital gains incurred on assets owned for more than a year.  

The discrepancy in tax rates boils down to the government affirming a longer-than-one-year held investment as a help to the economy. So, to encourage investors to hang on to their investments longer and help stimulate the economy by doing so, they tax capital gains differently based on the longevity of asset possession. The longer you’ve held the asset, the fewer taxes they impose on the capital gains.

Now, here’s the critical part – capital gains, no matter if they’ve been earned over months or years, cannot be taxed UNTIL you close your position. That is, your gains can’t be taxed until you decide to sell your asset and cash in on your investment.

When you do decide to cash in your investment and collect all your capital gains, that’s when the tax is applied to your gains. And at that point, there are a myriad of factors that will affect how much tax is imposed upon the capital gains you’ve accrued. Those factors are things like:

• (As previously stated) How long you’ve held the investment

• Your current income level

• The tax rate that the IRS is currently charging

• Cost basis of other investments

• Marital status

• Other factors

As anyone in the financial world will tell you, taxes can be a complicated issue. There are lots of moving parts, and the tax code is constantly shifting. So, getting to the bottom of the state of capital gains taxes usually requires either some digging by the investor or having someone on hand who is an expert on knowing how investments will be affected by tax rates. More on that in a second.

But for now, we want to hone in on just one more important part of all this capital gains conversation.

The Capital Gains Tax Present Reality 

The reason for the heightened level of importance now is that the current Presidential administration is considering raising the percentage at which capital gains can be taxed – and if that happens, capital gains will be taxed at a higher rate than ever before in our nation’s history.

For those in a lower tax bracket or who don’t have many investments in the market, the changes won’t feel that big.

But to anyone in a moderate to high tax bracket, who might be holding on to several investment types, they will feel these tax increases significantly, especially if they cash in their assets. We have many clients in that space, and so are watching the situation closely. Regardless, knowing the current state of capital gains tax law and how it could affect investments is either the work of a dedicated investment DIY’er or a financial expert.

As we mentioned at the top, we at McDowell are incredibly familiar with the capital gains tax conversation and all its intricacies. And because we help our clients know when to keep their investments and when it might be most advantageous to cash out, we continue to educate ourselves on all new developments on capital gains tax as the current reality continues to evolve.

For now, we just wanted to share a little of what we know about capital gains tax and why it might matter for Mr. or Mrs. Investor.

Got more questions about taxes, investing, or other financial topics? Reach out to us to learn more.