Investors frequently confuse the definition of capital gains and the way that capital gains are taxed. This article will break down the topic to assuage that confusion.
What are Capital Gains?
“Capital gains” are the increase in the value of a specific asset or good. Literally, the capital—or dollar value—of the asset has increased (gained). Capital gains become realized when the asset is sold—which is also when those gains could potentially be taxed.
Where might the average investor encounter capital gains? The stock market is the most common place. If a stock is purchased at $100 and sold at $150, then that $50 “profit” is deemed a capital gain. In some instances, that $50 will face a capital gains tax. In other cases, the entire $150 will be taxed as ordinary income. We’ll discuss later when each of those scenarios applies.
Short-Term vs. Long-Term Capital Gains
If the sale of a capital asset occurs within 1 year of its purchase, then those capital gains are deemed short-term.
If the sale of a capital asset occurs after 1 year of its purchase, then those capital gains are deemed long-term.
Short-term capital gains are taxed exactly like ordinary income. They share the same exact tax bracket.
Long-term capital gains are taxed at a rate lower than ordinary income, though there is no guarantee that future tax law changes won’t change this fact.
Capital Gains vs. Capital Losses
What if you lose money on capital investment? In that case, an investor might be able to claim a capital loss, which can be used to offset capital gains in the current year or in future years. Additionally, capital losses can be deducted against up to $3,000 in earned income per year.
When Do Capital Gains Apply? When Does Ordinary Income Tax Apply?
Capital gains tax only applies to certain investment accounts. Here’s a breakdown of a few common investment accounts, and which tax schemes apply to them.
Traditional 401(k) – Withdrawals after age 59.5 are taxed as ordinary income, not as capital gains. The full withdrawal is taxed (not ‘just the gains’).
Traditional IRA - Withdrawals after age 59.5 are taxed as ordinary income, not as capital gains. The full withdrawal is taxed (not ‘just the gains’).
Roth 401(k) – Withdrawals after age 59.5 are not taxed whatsoever.
Roth IRA – Withdrawals after age 59.5 are not taxed whatsoever.
Health Savings Accounts (HSA) – Withdrawals to pay qualified medical expenses are tax-free. Withdrawals after age 65 to pay non-qualified expenses (e.g. normal consumer spending) are taxed as ordinary income. The full withdrawal is taxed (not ‘just the gains’).
Taxable Brokerage Accounts – Withdrawals can be made at any age. The gains are taxed using the capital gains tax brackets (short-term vs. long-term, see above).
The “$40K Loophole”
The Federal tax code currently has one “loophole” on capital gains taxes that applies to lower earners. If someone’s combined income—ordinary income plus capital gains—is less than $40K, then none of the capital gains are taxed.
Example 1: This could be a retiree whose only income is coming from a taxable brokerage. They have no ordinary income. Therefore, their first $40K of capital gains each year are not taxed. Nice!
Example 2: This could be a “half retiree” who still keeps a part-time job. If their ordinary income is $25K, then their first $15K of capital gains each year are not taxed. Still quite nice!
This particular rule can turn taxable brokerage dollars into “Roth-like” dollars—they were taxed on the front end, but are not taxed on the back end.
Understandably, the delineation between ordinary income tax and capital gains tax can be confusing. However, it’s important for investors and their planners to understand which scheme to use, and when.