Taxes on Capital Gains

When you invest in stocks, bonds and other capital assets, you may also owe capital gains taxes on the profits from the sale of those investments.

Generally, if you sell an asset at a higher price than what you paid, you earn a capital gain. If you sell at a lower price than what you paid, you earn a capital loss.

The amount of capital gain is calculated by subtracting the basis from the price for which you sell the asset. You generally add the transaction costs to buy the asset to your basis.

The length of time that you hold your investment determines whether your capital gain is treated as a long- or short-term gain. The IRS sets the cutoff period at one year. That means that if you hold a capital asset for more than one year (i.e., 366 days), the capital gain you realize on its sale is considered a long-term capital gain. Short-term capital gains are those that you earn on sales of one year or less.

Short-term capital gains are taxed as ordinary income. Long-term capital gains, however, are taxed at a preferential rate. For all but the 10 and 15 percent tax brackets, the long-term capital gains tax rate is 15% on the sale of stocks, mutual funds and similar investments. Investors in the 10 and 15 percent tax brackets pay a long-term rate of 0% in 2009.

What kinds of income do stocks, bonds and mutual funds generate, and how is this income taxed?

Taxation on stocks. Stocks generate taxable income as dividends and capital gains. Generally, growth stocks don't pay dividends. Instead, investors expect to earn returns from an appreciation in the share price. Income stocks, on the other hand, generate regular dividend income. Since 2003, dividends have been taxed at the same rate as capital gains.

Taxation on bonds. Bonds are also called fixed-income securities since they often have a fixed coupon rate. As a result, the interest income that you earn is constant over the bond term. When you sell a bond for a higher price than you paid for it, you earn a capital gain. If you buy a bond at a discount and hold it to maturity, you earn a capital gain. If you buy a bond at a premium and hold it to maturity, you face a capital loss.

Taxation on mutual funds. With mutual funds, taxes are a little more complicated. That's because a mutual fund distributes capital gains and dividends from the portfolio of securities it holds. Distributed short-term capital gains are taxed as ordinary income and distributed dividends and long-term capital gains are taxed as long-term capital gains. When you sell shares of a mutual fund for a higher price than you paid, you pay either a short- or long-term capital gains tax, depending on how long you own the shares.

Investing has other tax rules related to capital gains, including:

The "wash-sale" rule. The "wash-sale" rule is aimed at preventing investors from selling a security to lock in a capital loss, immediately buying it back at a lower price. The IRS prohibits you from using the capital losses to offset capital gains if you buy back the same security within 30 days. To avoid being tripped up by the rule, you may wish to buy a different security that has a similar investment objective or similar risk characteristics to the one you sold.

Offsetting capital gains with losses. The IRS allows you to offset your capital gains with capital losses. If your losses exceed your gains, you can offset up to $3,000 of ordinary income in a year. If you have a larger amount of capital losses, you can carry them forward to future years. This is called the capital loss carryover rule.

For example, if you buy 100 shares at $10 each, and the share price grows at 5% per year, the share price in a year is $10.50. Since you have 100 shares, the amount of your capital gain is $50 (transaction fees are ignored).

If you are in the 25% tax bracket and sell 365 days later, you owe $12.50 in income taxes. If you wait for an additional day, you owe $7.50 in capital gains taxes.

How does this affect your rate of return? In the first case, your net profit on the sale is $37.50 ($50 minus $12.50). Your rate of return is 3.75% ($37.50 divided by your original investment of $1,000). In the second case, your net profit is $42.50. This gives you a rate of return of 4.25%, an extra 50 basis points for waiting one additional day.

For more on capital gains, see IRS Pub. 544.