Optimize Capital Gains Taxes
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Hi there! Whether you are looking to start investing or have already started doing it, at some point you will be faced with a question of taxes. Let’s take a look at what short and long-term capital gains are and why it is important to invest with a long-term mindset.
Capital gains is one of the most important terms that you have to learn. It is one of the key things you need to understand when investing. There are pros and cons depending on the investment strategy.
Short-term capital gains result from the sale of an investing asset owned for one year or less and are taxed as regular income. Long-term capital gains are generally taxed at a more favorable rate than regular income.
If you want to be a tax efficient investor then you see that short-term gains really are not what we want. A short-term gain is a gain where you have only held the business less than a year. When you have a short-term gain you are going to pay taxes as if you just went to your job and got paid at your job, so you are just going to pay ordinary income taxes on that capital gain. While long-term capital gains are the taxes you would pay if you held that stock for a year and a day, then you get to pay long-term gains. It is really important to understand the difference and particularly if you are making money, you are in the top tax bracket, and you live in some place like California, including state and federal taxes, you are looking at a little over 50% in taxes. It is a lot of money and you are not obligated to pay those long big taxes.
A better way is you could hold that capital asset for longer than a year and a day and suddenly your tax bracket drops on that particular amount of money that you made. Let’s stop right here and make sure it is clear to all readers. When you buy a stock and the price you pay is called basis. If, for example, you buy a stock for $75 that is your basis in that stock. That amount is also used for tax purposes and it is tax basis. If that $75 stock goes up and doubles up to $150 at some point after you bought it then you do not have to pay taxes on the first $75 because that is your basis. What you have to pay taxes on is everything over your basis. Back to our example, there is a $75 gain that goes into your taxes either short-term gain or long-term gain. If it goes into taxes as a short-term gain then you are going to pay like you just went down and worked. This is very popular among active investors especially those who do options trading and treat it like a job rather than investing. For everyone else it is highly important to get over that year and a day.
Imagine you are in the highest tax bracket living in a high cost of living area, so with short-term gain you will be paying 50% or more in taxes which results in only $37.5 that you can keep from the $75 you have earned. While with long-term gains you will only be paying 20% and keeping the rest $60 to yourself, that is a gigantic difference. Long-term capital gains tax can even be 0% if you are in a low enough tax bracket. If your tax rate is less than 15% then you could qualify for a 0% long-term capital gain rate which is fantastic.
At this point I hope you are with me on the idea that holding for a longer period of time to avoid short-term capital gains tax is the best investing strategy. Having said that, sometimes things are happening that might require that you sell a company before you have gotten there for a year. An important thing to outline here, if you invest in a broad stock market index then you should not have to sell anything before long-term capital gains kick in. Now, back to when you might want to consider selling early. The first thing is the company's price for whatever reason has gone up so far above its intrinsic value that the possibility of it continuing to go higher or to stay there in your opinion is very low. At this point taking those profits because it is very unlikely for the business to keep rocketing off might be a good idea.
Another reason when you might want to consider selling an investment is when the business’ story changes. Assuming the change is not for the better, it could be a change for better but let’s assume it is a negative change, the path of least resistance is to exit and go find a company that matches your values.
The third time when you might want to consider selling a stock is when you need the money for a better investment. It is for the time when you have found something that matches your values or just a better well rounded investment. Maybe you invested in a rapidly growing business that you are no longer interested in or simply want to rebalance your portfolio.
That’s the three major times when you might want to choose to sell, otherwise long-term capital gains is the way to go and you should stick to this strategy to get the most benefits of stock market investing.
