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Despite ongoing headwinds from the pandemic, the S&P 500 gained nearly 28% in 2021. That performance has likely made many investors happy, but capital gains taxes can eat away at those returns in the absence of smart tax management.
Learn what the federal capital gains tax is, how it’s calculated, and how to minimize its impact on your investment portfolio.
What is a Capital Gains Tax?
A capital gains tax applies to the net profit you earn from selling a capital asset. A profit means you sold the asset — stocks, bonds, or investment real estate, for example — for a higher price than you bought it for.
Capital gain = Sale price – purchase price
If you also have capital losses for the year, you may be able to net the gains against the losses to reduce how much of your gains are taxable.
The capital gains tax is mostly progressive, similar to income tax, where tax rates increase as your income increases. The rates range from 0% for the lowest earners to 20% for the highest earners. The exceptions are certain real estate gains and collectibles, which are taxed at flat rates of 25% and 28%, respectively.
Exactly how much you pay in capital gains tax depends on how long you hold an asset — either short term or long term — and your annual taxable income. You have to sell an asset to trigger a capital gain; it’s considered an unrealized gain if an asset increases in value while you still own it.
Importantly, capital gains taxes don’t apply to investment gains in tax-deferred retirement accounts like 401ks and IRAs. Even if you sell assets within those accounts, you won’t owe capital gains taxes on any profit — unless you take an early withdrawal. You don’t get off scot-free, though. Withdrawals from retirement accounts are later taxed at your ordinary income rate, which may be higher than your capital gains rate.
Key Tax Considerations
Net short-term capital gains are added to annual income and taxed at ordinary rates, ranging from 10% to 37%.
Net long-term capital gains are not included in your income — they are taxed separately. However, your taxable income does determine whether your long-term capital gains are taxed at 0%, 15%, or 20%.
Capital losses are the result of investments sold for a lower price than they were purchased for. These losses can be used to offset capital gains, though limits apply.
If you have a taxable capital gain, you may have to make estimated tax payments to the IRS.
If your income exceeds certain thresholds and includes investment income such as short- and long-term capital gain, you could owe an additional 3.8% net investment income tax.
Read More: Guide to Filing Your Taxes in 2022
What’s the Difference Between Short-Term and Long-Term Investments?
Before we dig into the difference between short-term and long-term investments, it’s important to know what’s considered a capital asset. Stocks, bonds, mutual funds, real estate, jewelry, artwork, cars, and anything else you own and use for personal or investment purposes is a capital asset. Whether it’s a long-term or short-term investment only comes into play when you sell the asset.
Long-term investments are assets you hold for one year or longer. Short-term investments are assets you hold for less than one year. This timeframe, also known as your holding period, is measured from the day after you buy the asset to the day you sell it.
Long-term investments are generally preferable because you unlock lower tax rates. Long-term capital gains rates top out at 20%, except in the case of collectibles or certain real estate. Gains on short-term investments are taxed at ordinary income rates, which top out at 37%.
Long-Term Investments
If you have long-term capital gains, use the following tables to find your tax rate. First find your filing status and then find the bracket corresponding to your total taxable income for the year.
Long-term capital gains rates for 2021
Tax rate
Single
Married filing jointly
Head of household
Married filing separately
0%
$0 to $40,400 or less
$0 to $80,800
$0 to $54,100
$0 to $40,400
15%
$40,401 to $445,850
$80,801 to $501,600
$54,101 to $473,750
$40,401 to $250,800
20%
$445,851 or more
$501,601 or more
$473,751 or more
$250,801 or more
Long-term capital gains rates for 2022
Tax rate
Single
Married filing jointly
Head of household
Married filing separately
0%
$0 to $41,675
$0 to $83,350
$0 to $55,800
$0 to $41,675
15%
$41,676-$459,750
$83,351-$517,200
$55,801-$488,500
$41,676-$258,600
20%
$459,751 or more
$517,201 or more
$488,501 or more
$258,601 or more
There are exceptions to the tables above. If you have a net long-term capital gain from the sale of a collectible — stamps, coins, or art, for example — then your gain will be taxed at 28%, regardless of your income. Also, selling a collectible at a loss may not be able to reduce your gain.
Any taxable portion of section 1202 qualified small business stock is also taxed at 28%.
When section 1250 property — usually depreciated real estate, such as an office building — is sold and results in a gain, that amount is taxed at ordinary income rates with a maximum of 25%.
Real estate that’s used as a primary residence also has special rules. If you sell your home for a profit, the first $250,000 — or $500,000 if you’re married and file taxes jointly — is exempt from capital gains tax.
Pros of long-term investments:
High earners can unlock lower tax rates on investment gains.
Low earners can avoid taxes on investment gains.
Cons of long-term investments:
If day trading is your preferred investment strategy, holding on to a stock for more than a year might not make sense.
Short-Term Investments
Gains from short-term investments are taxed at ordinary income rates, as outlined in the following tables. When you have a short-term capital gain it will be included in your gross income. It won’t be taxed separately like a long-term capital gain.
Short-term capital gains rates for 2021
Tax rate
Single
Married filing jointly
Head of household
Married filing separately
10%
$0 to $9,950
$0 to $19,900
$0 to $14,200
$0 to $9,950
12%
$9,951 to $40,525
$19,901 to $81,050
$14,201 to $54,200
$9,951 to $40,525
22%
$40,526 to $86,375
$81,051 to $172,750
$54,201 to $86,350
$40,526 to $86,375
24%
$86,376 to $164,925
$172,751 to $329,850
$86,351 to $164,900
$86,376 to $164,925
32%
$164,926 to $209,425
$329,851 to $418,850
$164,901 to $209,400
$164,926 to $209,425
35%
$209,426 to $523,600
$418,851 to $628,300
$209,401 to $523,600
$209,426 to $314,150
37%
$523,601 or more
$628,301 or more
$523,601 or more
$314,151 or more
Short-term capital gains rates for 2022
Tax rate
Single
Married filing jointly
Head of household
Married filing separately
10%
$0 to $10,275
$0 to $20,550
$0 to $14,650
$0 to $10,275
12%
$10,276 to $41,775
$20,551 to $83,550
$14,651 to $55,900
$10,276 to 41,775
22%
$41,776 to $89,075
$83,551 to $178,150
$55,901 to $89,050
$41,776 to $89,075
24%
$89,076 to $170,050
$178,151 to $340,100
$89,051 to $170,050
$89,076 to $170,050
32%
$170,051 to $215,950
$340,101 to $431,900
$170,051 to $215,950
$170,051 to $215,950
35%
$215,951-$539,900
$431,901 to $647,850
$215,951 to $539,900
$215,951 to $323,925
37%
$539,901 or more
$647,851 or more
$539,901 or more
$323,926 or more
Pros of short-term investments:
Holding an asset for less than a year may be necessary if you’re looking for immediate growth or income from your investment portfolio.
Cons of short-term investments:
Your net capital gains will be taxed at the same, usually higher, rates as your ordinary income.
Tax-Loss Harvesting
One strategy for minimizing capital gains taxes is called tax-loss harvesting. Essentially you sell some of your investments at a loss to offset the investments that have gained value. Typically, tax-loss harvesting works best through portfolios of individual stocks in taxable investment accounts. You sell stocks within your portfolio that have dropped in value, and ideally, you sell enough stocks that have lost value to cover the amount of appreciation from the stocks you are selling for a gain.
You can even offset up to $3,000 in other income if your capital losses exceed your capital gains. Tax-loss harvesting can help you rebalance your stock portfolio at the same time, and can result in a higher net after-tax return.
Tax-loss harvesting works even if you want to maintain exposure to the stocks that have lost value, but there are some limitations. The wash sale rule restricts you from repurchasing the same or a substantially similar stock within 30 days before or after selling at a loss. If you violate that time frame, you won’t be able to claim a loss.
You can, however, buy an exchange traded fund covering the broad market and hold it during the wash-sale period. This allows you to maintain exposure to the industry until you can repurchase the stocks you sold. If the security you sold was a basket of stocks, such as an ETF, you cannot simply buy the same type of ETF from another provider. Tax-loss harvesting can be complex, so consulting a financial or tax advisor is recommended.
Read More: Guide to Tax-Loss Harvesting
Capital Gains Tax Strategies
Use tax-advantaged retirement accounts to defer taxes on your investment gains.
Donate appreciated investments to charity to avoid capital gains tax and receive a tax deduction.
Keep investments for longer than one year to unlock favorable tax rates.
Consider selling highly appreciated long-term investments in lower income years to qualify for lower capital gains rates.
Make sure your investment advisor — robo or human — uses tax-loss harvesting.
Dig Deeper
What are capital losses?
Capital losses are the result of selling an investment for less than you paid for it. For example, buying a stock for $700 and later selling it for $500 equals a loss of $200. You can use capital losses to offset capital gains and thus reduce taxes. If you don’t have capital gains to offset, you can use up to $3,000 in capital losses per year to offset your ordinary income.
Capital gains and state taxes?
Most with an income tax also tax capital gains, though it’s usually not a separate tax rate. Check your state’s department of revenue or taxation website for exact rates.
Capital gains special rates and exceptions?
Most capital gains are taxed between 0% and 20%, but certain alternative investments are taxed at higher rates. Section 1250 depreciable real estate (usually office or commercial buildings) is taxed up to 25%, while collectibles and section 1202 qualified small business stock are taxed at 28%.
Gains from the sale of residential real estate — as long as you own and lived in the property for two of the last five years — are partially exempt from taxation. Up to $250,000 in profits for single filers and $500,000 in profits for married joint filers is not subject to capital gains tax.
How to minimize capital gains taxes?
One way to avoid capital gains taxes is to invest within tax-deferred retirement accounts. Because these accounts are shielded from current taxation, you can buy and sell as much as you want without triggering capital gains taxes. However, distributions taken in retirement will be taxed at your ordinary income tax rate.
A popular strategy to minimize capital gains taxes in non-retirement investment accounts is tax-loss harvesting. Many investment advisors use this method of strategically selling investments at a loss to offset gains on appreciated investments. If your annual losses and gains net to $0, then you won’t be subject to capital gains tax. If your losses exceed your gains for the year, then you may be able to reduce your taxable income.
Want a better way to manage your investments? Millions of people use Personal Capital’s free and secure online financial tools to see all of their accounts in one place, analyze their investments, and plan for long-term goals, like buying a house or saving for retirement.
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Author is not a client of Personal Capital Advisors Corporation and is compensated as a freelance writer.
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. Compensation not to exceed $500. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money. Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.
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