The Lowdown on Capital Gains Taxes

     It is easy to see what is so attractive about “timing” the stock market — buying stocks, bonds, or funds after an atypically awful week on Wall Street, then turning them around a few weeks later when the inevitable rebound takes place. The market has its somewhat predictable ups and downs, and anyone with half a brain knows when it’s been taking a beating, right? A tricky little item that many young and first-time investors have no idea about, though, is the pitfall of capital gains taxes. When you invest in any capital assets (stocks and bonds, etc.), you may very well also owe capital gains taxes on the profits from the sale of those investments. This one messed me up pretty good the first (and only) time I sold a mutual fund after making a quick profit.

     If you sell an asset at a higher price than what you paid, you usually earn what is known as a capital gain. (If you sell at a lower price than what you paid, likewise, you earn a capital loss, which can actually be pretty darned helpful come tax time — but that is for another article.) The amount of capital gain is, quite simply, calculated by subtracting the basis — the purchase price plus most transaction costs — from the price for which you sell the asset.

     The length of time that you hold said investment determines whether your capital gain is treated as a long- or short-term gain; if you hold a capital asset for more than one year, the capital gain you realize on its sale is considered a long-term capital gain. Less than a year, you are looking at the dreaded short-term tax. See, short-term capital gains are taxed as ordinary income. Long-term capital gains, however, cut you a great break – you’ll pay only 5-15% tax. Not so bad.

     Let us take a gander at your most basic capital assets one by one:

Stocks. For the most part, growth stocks don’t pay dividends. Instead, investors expect to earn returns from an appreciation in the share price. Income stocks, though, generate regular dividend income. Dividends are, unfortunately, taxed at the same rate as capital gains.

Bonds — also called fixed-income securities. The interest income that you earn is constant over the bond term. Sell a bond for a higher price than you paid for it, you earn a capital gain. If you buy a bond at a premium and hold it to maturity, however, you face a capital loss.

Mutual funds. They’re a bit more complicated. A mutual fund distributes capital gains and dividends from its securities portfolio. Distributed short-term capital gains are taxed as ordinary income, while distributed dividends and long-term capital gains are taxed as long-term capital gains. Note: When you sell a mutual fund at a higher price than you initially paid, you pay either a short- or long-term capital gains tax, depending on how long you held the shares.

     It might sound like a bit much, but your tax professional (or software equivalent) will take care of it all for you in April. The important thing for now is to know about the penalties you can incur for flipping stocks and bonds. Whether it’s worth it or not is your call.