Understanding Capital Gains Tax

What is Capital Gains Tax?

Capital gains tax applies to profit from selling investments. When you sell stock for more than you paid, the IRS wants a cut of that profit. The tax rate depends on how long you held the investment and your income level.

This tax significantly affects your actual returns. A 20% stock gain becomes smaller after taxes. Understanding capital gains tax helps you make smarter investment decisions and keep more of your profits.

Short-Term vs Long-Term Capital Gains

The holding period determines your tax rate. Hold a stock for one year or less and you pay short-term capital gains tax. Hold for more than one year and you pay the lower long-term rate.

2024 Tax Rate Examples

Tax rates change based on filing status and income. Here are typical scenarios showing the difference holding period makes.

How to Calculate Your Tax

Start with your gain: selling price minus purchase price and any fees. Then determine if the gain is short-term or long-term based on holding period. Apply the appropriate tax rate to find your tax liability.

Strategies to Reduce Capital Gains Tax

Hold for Long-Term Rates

Waiting one year drops your tax rate dramatically. If you bought stock 11 months ago and want to sell, consider waiting one more month. The tax savings often exceeds any short-term price movements.

Tax-Loss Harvesting

Sell losing positions to offset gains. If you have $10,000 in gains and $4,000 in losses, you only pay tax on $6,000 net gain. You can deduct up to $3,000 in excess losses against ordinary income annually.

Use Retirement Accounts

Investments in 401(k) or IRA accounts grow tax-deferred. You pay no capital gains tax on trades within these accounts. Roth IRAs offer tax-free growth if you follow the rules.

Time Your Sales

Spread large gains across multiple tax years to stay in lower brackets. Selling everything at once might push you into a higher tax tier. Strategic timing reduces overall tax burden.

Special Situations

Inherited Stock

Inherited shares get a step-up in cost basis to the value on the date of death. This erases all previous gains. If you sell immediately, you owe little or no capital gains tax.

Gifts of Stock

When you gift stock, the recipient takes your cost basis. If you bought shares at $20 and gift them at $100, the recipient owes tax on the $80 gain when they sell.

Wash Sale Rule

You cannot deduct a loss if you buy the same stock within 30 days before or after selling. The IRS prohibits this tax avoidance tactic. Wait 31 days or buy a similar but different stock.

State Capital Gains Tax

Most states tax capital gains as ordinary income. California, New York, and other high-tax states add substantial state tax on top of federal tax. A few states like Florida, Texas, and Nevada have no state income tax at all.

Factor in state taxes when calculating your real after-tax return. A California resident in the top bracket might pay 37% federal plus 13.3% state tax, totaling over 50% on short-term gains.

Record Keeping Requirements

Keep detailed records of all stock purchases and sales. Note the date, number of shares, price paid, and fees. You need this information to calculate gains accurately and prove your cost basis to the IRS.

Brokers report sales on Form 1099-B but may not track your cost basis correctly, especially for older positions or transferred accounts. Maintain your own records as backup documentation.