You know you have to pay taxes on income. But you might not realize that investment earnings are taxable, too. Enter: capital gains taxes.
Break it down for me.
A capital gain is the profit you earn from selling an asset that increased in value. Think: your home, stocks, bonds, cryptocurrencies, and even your stamp collection. When you sell that asset for more than you paid for it, the capital gain is considered "realized" – and taxable.
How much tax are we talking?
That depends on how long you owned the asset. There are two types of capital gains:
Long-term gains = profits from assets you’ve held for more than a year. And they get their own, lower tax rates: 0%, 15% or 20%, depending on your income. Alternative investments, like collectibles and antiques, are taxed at a 28% rate. (Psst...President Joe Biden has proposed raising the top long-term capital gains rate to 39.6% for anyone making more than $1 million a year.)
Are there any exceptions?
Good question. Yep, there are a few. One is for your primary residence (hint: the IRS defines this as the home you’ve owned and lived in for at least two of the last five years). If you sell your home for more than you paid for it, you don't have to pay capital gains taxes on the first $250,000 of profit if you're a single filer. (Make that $500,000 of profit for joint filers.) Any profit above that threshold gets taxed.
Another big exception: your retirement account. If you’re contributing to a 401(k), IRA or similar account, investment earnings aren't subject to capital gains taxes.
Aaand one more: inheritances. When someone leaves you an asset, its value is "stepped up." Meaning it doesn't matter what the original value (aka "basis") of the asset was when it was first purchased. Instead, the basis is the value of the asset when you inherit it. If you sell it immediately, you'd owe little to no capital gains taxes on it. Even if it's grown a lot in value since the original person bought it. At least that's how it works now. The Biden admin has also proposed closing the "stepped-up basis" loophole.
Good to know. So how do I report capital gains on my taxes?
In most cases, you add up all your short-term gains and all your long-term gains, and report them separately on your Form 1040. And if you sold an asset that generated a large capital gain, you might have to pay estimated quarterly taxes. (The IRS has a questionnaire to help you figure out if that’s you.)
Pro tip: you can "offset" gains with any investment losses you realized in the same year to help minimize your tax bill. This move is called tax-loss harvesting. For example, if you gained $100 by selling a winning stock, you can sell another stock that lost $100 (or more) to wipe away any capital gains tax.
Before you buy and sell your non-retirement investments, look into what that’ll mean for you during tax season. Because if you make a profit, the gov will want some of your winnings. So make sure your wallet is ready.
Subscribe to Skimm Money
Your source for the biggest financial headlines and trends, and how they affect your wallet.