Timing is Everything: What You Need to Know About Capital Gains and Taxes
As you profit, so shall you be taxed.
That’s certainly one reality of investing, but there’s a smart way to address the process, especially when it comes to timing the sale of your stocks.
Let’s take a look at the ins and outs of capital gains, taxation, and consider a key strategy that can help keep taxes manageable as you build on (and profit from) your portfolio.
What are Capital Gains?
First, consider what the government will look at when tax time comes around. Any time you buy a share of stock, or any kind of security, you pay the cost associated with that product.
Let’s say it’s the fictional company GeoProof Devices, a maker of global-positioning system hardware. You buy 1,000 shares at $55 per share.
As the company links up with the growing mobile sector, however, its stock price shoots up to $76.50. Now you’ve got $76,500 in the chute.
The difference between the price for which you can now sell your GeoProof shares and the price for which you bought them, $21,500 on the whole lot, is what we call capital gain. Until you sell it, it’s known as unrealized capital gain. Once you take the money from a buyer, it’s realized.
Estimating Tax on Capital Gains
That $21,500 is money that the IRS will seek a piece of. Exactly what percentage depends on a few factors. Key among them is the term for which you hold the investment.
- Short-Term Capital Gains Tax: If you bought your GeoProof shares in January and the company’s reported earnings caused the stock to soar in June, and that’s when you sell, then you’re dealing with a capital gain known as short term (you held the investment for less than a year). If you sell all 1,000 shares, you’ll be taxed on the $21,500 according to your income-tax bracket percentage. That is, if you’re paying 33% annually, then the government gets $7,095 of your profit on the stock sale. You net $14,405 after taxes. Not bad. But let’s look at how it could get better.
- Long-Term Capital Gains Tax: Say you decide to sit on the GeoProof shares a while longer. You watch what happens until February of the following year. Now you’re in the long-term investment category. Turns out that GeoProof’s price peaked that previous summer, but then luckily held steady at $76.50. You sell all 1,000 shares making a cool profit of $21,500, but because you held onto the share for longer the IRS taxes that amount at only 15% — a rate much lower than it would have if you’d sold the June before. And so, you net a post-tax profit of $18,275.
- Low v. High: Our example represents an investor in the higher income tax bracket of 33%. What if you’re paying out in the lower brackets, say 10%–15%, and then you sell under the long-term conditions. Answer: long-term capital gains tax rate dips to 5% in most cases. Those GeoProof shares could net you $20,425!
The Strategic Take-Away
Based on the above, if the price of a stock holds steady, then waiting for the long-term capital gains tax rate increases your net profit.
Take note, however, of politics circa 2012. Both President Barack Obama and leading Republican opponents in the year’s national elections are after a change to the way capital gains tax works.
One way it could go: the long-term capital gains tax-rate breaks could vanish, and everyone would pay 20% on investments held for longer than a year.
So, a word to the wise, the early months of 2012 could be a prime time to look at your portfolio and consider what’s in it and for how long.