Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.
Depending on the length of time that you've owned an asset, there are different capital gains taxes that come into effect. This lesson will help you ascertain the difference between short-term and long-term capital gains taxes.
Capital Gains Treatments
Congratulations! The stocks you purchased on a whim have grown dramatically in value, which means that you are now in control of a small fortune! You proved all the naysayers wrong - widgets really were the wisest investment of the last quarter. Excitedly, you go to meet your investment advisor, eager to cash out the stocks and buy a small tropical island with a big yacht.
Understandably, your investment advisor is happy to meet with you. After all, you just became his richest client! However, there's a catch. You've got to determine the proper capital gains treatment on your stock to make sure that you pay the proper capital gains tax. Remember that capital gains taxes are those taxes paid on income derived from investments.
Short- and Long-Term Capital Gains
After the usual niceties, your investment advisor asks you how long you've owned the stocks in question. As it turns out, you've owned your widget company shares for a bit over ten months. However, because the total time owned is still less than a year, you are liable for short-term capital gains taxes. You expected a tax, but not quite one this big! It turns out that the IRS can claim up to 35% of your total profits as income taxes, all because you owned the stock for less than one year. Quickly, you ask what the alternative is.
Luckily, your investment advisor has just the answer. If you own a stock or a security for more than a year, you can sell it and have the profits treated as long-term capital gains. While short-term capital gains taxes are up to 35%, long-term capital gains taxes are rarely more than 15% at the federal level. In other words, if you hold on to your stock for just two more months, you'll get 20% more money!
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But wait, you suggest, isn't it better to sell now? After all, you have no way of predicting the future. However, your advisor tells you, in most cases, it is still better to hold on to the stock and wait for long-term capital gains to take effect. Unless your security loses more than 20% of its value, you'll still come out with more money.
Why This Matters?
At this point, you may be wondering why there is a difference between long-term and short-term capital gains taxes. The answer is relatively straightforward and two-fold. First of all, a lower long-term capital gains tax encourages people to save for the future. The money that they invest will hopefully grow, and while they will have to pay taxes on it, it is only on the profits.
Meanwhile, a higher short-term capital gains tax helps prevent people from taking too much of a speculative role in the market. If you are constantly trying to 'game' the market, eventually your taxes will catch up with you.
In this lesson, we learned about proper capital gains treatment when selling both long-term and short-term investments. We learned that long-term capital gains tax is applied for investments that are held for more than one year, and are rarely more than 15% of the total profit. Meanwhile, short-term capital gains tax applies when investments are held for less than a year, and can reach 35%!
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