Tax Bite: Capital Gains, Short-Term and Long-Term Investments

When an asset is sold for a profit, Uncle Sam wants his share. But depending on your level of taxable income, your capital gains rate might be lower than your ordinary income rate. Here’s a rundown.

https://tickertapecdn.tdameritrade.com/assets/images/pages/md/Tax bite: How capital gains taxes work
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Key Takeaways

  • Short-term capital gains are taxed as ordinary income; long-term gains are taxed at lower rates
  • For 2020, capital gains tax rates range from zero to 20%, but policymakers occasionally alter these rates and thresholds
  • Certain derivatives are taxed at a blended 60/40 rate of long-term and short-term capital gains

Having a new stock in your portfolio can make you feel like a kid who’s just unwrapped a holiday present. After a long wait and careful study, you chose what you wanted, and now it’s there, bright and shiny in front of you (on your screen, not the living room floor, of course). 

If shares of that stock rise, it can also be exciting to sell the stock and pocket some gains after that initial investment pays off. Unfortunately, there’s a twist we all must face that saps some of the joy, just like going back to school when the holiday is over. We’re talking, of course, about capital gains taxes.

If you happen to sell a security, an investment, or another asset at a higher price than you bought it, you’ve created a capital gain—and, like other types of income, Uncle Sam wants his share. (If you sell and lose money on the asset, that’s considered a capital loss and has a different set of tax consequences—another discussion.)

What Are Capital Gains?

From the standpoint of the Internal Revenue Service (IRS), capital gains are an add-on to income and must be reported as such. Strictly speaking, the IRS considers any gain on any asset fair game. The gain is calculated by subtracting the adjusted cost basis of the asset from the amount you realized on the sale, according to the IRS. That, of course, includes boats, cars, and stocks, as well as the profit you might make from selling that retro pair of basketball sneakers or your prized 1952 Mickey Mantle baseball card (yeah, right). 

What’s the Difference Between Long-Term and Short-Term Gains?

In terms of taxes, plenty, according to the IRS. Long-term gains—those held for longer than a year—are taxed at lower rates than ordinary income rates. Short-term tax gains are taxed at the same rate as your ordinary income, so there’s no tax benefit tied to them. 

(Learn more about marginal tax rates and the 2020 brackets for ordinary income.) 

If you buy and sell an asset during a one-year period and make a profit, that’s considered ordinary income, and booked as a short-term gain. (There are some exceptions, such as gifts and inheritances.) 

What are the Capital Gains Tax Rates?

For 2020 until at least 2025, if you record a short-term profit and add it to your ordinary income, the ordinary tax rates range from 10% to 37%. The maximum tax, if it included the 3.8% Net Investment Income Tax (NIIT) applied to individuals, estates, and trusts that have income above the statutory thresholds, would be 40.8% on short-term gains.

Hold on to that asset for longer than a year before you sell it, and it falls into the long-term gains column. (Certain capital gains tied to partnership interests held in connection with the performance of investment services now require a three-year holding period to be called a long-term gain. Again, that’s another discussion.)

Could Tax Rates for Long-Term Gains Change?

Possibly. As of 2020, the tax rates for long-term gains rates range from zero to 20% for long-term held assets, depending on your taxable income rate. For the present, long-term capital gains taxes do not exceed 23.8%, including the 3.8% NIIT. See the table below, but note, it doesn’t include the NIIT.

Your Taxable Income (Single)Your Taxable Income (Married Filing Jointly)Long-Term Capital Gains Rate (as of 2020)
$0–$78,750$0–$78,7500%
$78,751–$434,550$78,751–$488,85015%
Above $434,550Above 488,85020%

However, elections do happen, and power in Washington, D.C., sometimes changes. 

Democrats have historically been the ones more eager to raise capital gains taxes, while Republicans have sought to lower them, although there have been exceptions (tax rates fell during the two terms of Democratic President Bill Clinton in the 1990s, for instance). 

Both parties have cut down forests’ worth of paper explaining why their ideas on the subject make sense, so you’re free to decide where you stand. Either way, it’s important to keep an eye on Washington if you’re an investor to see if those rates move higher at some point—or alternatively, disappear entirely, as some politicians have proposed.

Back in the late 1970s, the maximum long-term capital gains rate rose to near 40% for some investors with the biggest gains. The maximum rate recently fell to its lowest level ever. 

Eventually, you might want (or need) to cash at least some of your capital gains, but deciding on the timing is important. If you think Washington is likely to change the law in the near future, you might decide to hold on a bit longer if you think rates might go down or get out a little earlier if you’re worried they could rise. It’s always up to the individual investor, of course, and depends on how quickly you need your profits.

What About Special Taxation Rules for Derivatives?

Do you trade futures, options on futures, or options on broad-based indices such as the S&P 500 (SPX) or Nasdaq-100 (NDX)? If so, congratulations—you get to claim special “marked-to-market” status for these so-called Section 1256 contracts.  

What does this mean? Regardless of whether you liquidated a position by the last trading day of the year, the IRS treats it as if you did, and uses the closing price of that final trading day to figure your unrealized gain or loss. The closing price is “marked” and used as the cost basis going forward.

The profit and loss for tax purposes is split into two capital gains buckets—60% is considered long-term capital gains and 40% short-term capital gains—regardless of how long you held the position.

(Read more on tax rules on Section 1256 contracts.)

Tax policy, marginal rates, and capital gains taxes can border on the complex—and can sometimes be a moving target. And remember: these are only federal rates. Many states tack on their own capital gains taxes. If you have questions, you might want to consult a tax or estate-planning professional. And if you’re a TD Ameritrade client, you can always turn to the Tax Resources center.

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Key Takeaways

  • Short-term capital gains are taxed as ordinary income; long-term gains are taxed at lower rates
  • For 2020, capital gains tax rates range from zero to 20%, but policymakers occasionally alter these rates and thresholds
  • Certain derivatives are taxed at a blended 60/40 rate of long-term and short-term capital gains

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