The long-term capital gains tax has been around since 2008. However, a lot of investors do not know about the 0% capital gains tax rate that is applicable to long-term capital gains. Income plays an important role in the 0% threshold, so let’s delve into how to gain tax-free earnings on your investments.
What is capital gain?
A capital gain occurs when you sell an asset for a higher price than you originally paid at the time of purchase. To explain this with an equation, capital gains would translate to
Capital Gain= Selling Price − Purchase Price
What is meant by capital gains tax?
Just like how the Government levies a cut on your income, it does the same on the profit you made on your investments. The capital gains tax, is thus, the levy on the profit made by you on an investment when it is sold. When taxable assets such as stocks are sold, the capital tax charged on them is referred to as ‘realized.’ The capital gains tax does not apply to investments that are unsold or ‘unrealized.’ As such, the tax on stock gains does not incur unless the stocks are sold, even if you keep the shares for a long period of time or if their value increases. To gain how taxes could affect your financial planning goals and needs, get in touch with a professional financial advisor who can advise you on the same.
Important points to remember:
- Capital gains tax incurs only after the investment is sold.
- Assets that qualify for capital gains taxes include bonds, stocks, coin collections, jewelry, vehicles, and real estate.
- As per the existing federal tax policy, the capital gains tax rate is applicable only on profits incurred on the sale of assets that were held for more than a year. This is referred to as ‘long-term capital gains.’ The long-term capital gains tax rates are 0%, 15%, or 20%, based on the taxpayer’s tax bracket for that year.
- Short-term capital gains tax is levied on assets that are held for a year or less. These are taxed as ordinary income. For most taxpayers, long-term capital gains tax is levied at a lower rate than short-term capital gains tax.
- For tax purposes, capital gains reflect in your adjusted gross income. Should you have substantial capital gains from trading or investing, there are chances that you will fall in the higher tax bracket income.
How do capital gains tax work?
Let’s suppose you have bought 100 shares of a certain company with the stock costing $20 per share. That brings your investment value to $2,000. Now, if you sell them after more than a year for $50 per share, your capital gain is $3,000.
Now, assuming that you come under the income category where long-term gains are taxed at 15%, i.e., $450, the profit you will get after-tax will stand at $2,550.
How does the 0% capital gains tax rate work?
The 0% capital gains tax rate applies to married taxpayers who file joint returns together with a six-figure taxable income of up to $80,800 and to single tax filers with taxable incomes up to $40,400 as of 2021. In 2022, the 0% capital gains tax has risen to $83,350 for joint filers and $41,675 for single taxpayers.
The capital gains tax rate on long-term capital gains is 0%, 15%, or 20%. Remember, the tax rates apply only to long-term gains on capital assets that have been held for more than one year.
Some years you may have less taxable income as compared to others. You can also make a low-tax year on purpose, especially in your retirement years, by carefully choosing the accounts to withdraw from each year.
How much capital gains tax is applicable for married and single filers?
Let’s consider an example for each type—
1. For married filers filing taxes jointly
Assume a married couple who are filing for capital gains tax for 2021 make a joint gross income of $100,000. The standard deduction of $25,100 is common for joint filers, so the couple’s taxable income is reduced to $74,900, i.e., less than the $80,800 threshold for 0% long-term capital gains tax. Now, after subtracting the itemized deductions above $25,100, the couple may file a higher reduction and yet gain more income while being below the taxable limit.
2. For single filers
Assume a single taxpayer purchases a house for $200,000 and sells it later for $500,000 with a $300,000 profit on the sale. After applying for the $250,000 exemption, the amount of $50,000 will be affected by the capital gains tax.
Capital gains tax rate for 2022
|Long-term capital gains rate||Taxable income|
|0%||$0 to $41,675|
|15%||$41,676 to $459,750|
|20%||$459,751 or more|
|Married filing jointly|
|0%||$0 to $83,350|
|15%||$83,351 to $517,200|
|20%||$517,201 or more|
How to avoid capital gains tax on stocks
Following are some of the common tips to avoid capital gains tax on stocks:
1. Investing for a longer-term
The key is to track down companies with the best stocks. This way, you can hold the stocks for a longer term and pay the lowest rate of capital gains tax. Of course, this is not as easy as it sounds. A company’s assets and fortunes are subject to change, and you might also need to sell the stock earlier than anticipated.
2. Using capital losses to offset gains
Capital gains can be offset by losses (in investments). Many investors take advantage of losses on their investments by lowering the tax on their investment profits.
For instance, you have two stocks; one is worth 10% more than the original price you paid, while the other is worth 5% less. Now, if you sell both stocks, the loss on one stock would decrease the capital gains tax that is due on the other. Of course, you would want profits on all your investments, but losses are inevitable, and you can lessen their impact in this way.
3. Keeping a check on your holding periods
Make sure you keep a check on the trade date of the security’s purchase, especially during the sale of the security that was purchased a year ago. If the price of your investment is holding steady, you might want to wait for a month or so to complete the holding period for long-term capital gains tax bracket.
4. Picking your cost basis
If you have shares of the same company but at different times and prices, you will have to pick the cost basis when you sell the shares. To calculate the cost basis, investors commonly apply the first-in, first-out (FIFO) method. However, there are four other methods that you may use: last in, first out (LIFO), dollar value LIFO, the average cost (only for mutual fund shares), and specific share identification.
Consulting a tax advisor is always a wise decision, especially if you are selling a holding of a substantial amount.
5. Harvesting gains
Gain harvesting is productive in realizing gains that are tax-free. To make this work, you need to inculcate the habit of projecting taxes and be on the lookout for tax opportunities at the end of each year. By harvesting gains consistently, you can decrease your tax bill during your retirement years. However, if you miscalculate, it may cost you a lot of money.
6. Benefitting from tax-deferred retirement plans
With investments made through a retirement plan, such as a 401(k), 403(b), or individual retirement account (IRA), your money grows exponentially without being subject to immediate taxes. As such, to avoid capital gains tax, you may buy and sell investments within your retirement account.
With traditional retirement accounts, your profits are taxed as ordinary income on withdrawal. However, by the time you withdraw, you may fall in the lower tax bracket than the time you had started your investment. In the case of Roth IRA accounts, your withdrawal money is tax-free, provided you adhere to the IRA rules for withdrawing your funds.
Some investors advocate that a low rate on capital gains is an effective way to save money and also to invest in stocks and bonds. Increasing investment boosts economic growth, and businesses get the room for expansion, innovation, and employment. Another point that stands in favor of capital gains tax is the use of after-tax income to purchase assets. When the money used to buy stocks or bonds is already taxed as ordinary income, the addition of capital gains tax leads to double taxation. If you have any doubts, you can reach out to a professional financial advisor for effective capital gain tax management.
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