What is Capital Gains Tax?
Capital gains tax is the tax you pay on the profit when you sell an investment for more than you paid for it. If you buy stock for $5,000 and sell it for $8,000, your capital gain is $3,000, and you owe tax on that $3,000. The tax rate depends on how long you held the investment.
Short-Term vs Long-Term Capital Gains
- Short-term (held less than 1 year) — Taxed at your ordinary income tax rate. If you are in the 24% bracket, your short-term gains are taxed at 24%. This is why day trading and frequent trading is tax-inefficient
- Long-term (held more than 1 year) — Taxed at preferential rates: 0%, 15%, or 20% depending on your income. Most people pay 15%. Single filers earning under ~$47,000 pay 0% on long-term gains
Example: You earn $70,000/year and sell stock for a $10,000 profit. If held less than 1 year: taxed at 22% = $2,200 tax. If held more than 1 year: taxed at 15% = $1,500 tax. Holding one extra day saved $700.
Strategies to Minimize Capital Gains Tax
- Hold for at least one year — The simplest and most effective strategy. Long-term rates are significantly lower than short-term
- Tax-loss harvesting — Sell losing investments to offset gains. $5,000 gain + $3,000 loss = only $2,000 taxable gain. You can also deduct up to $3,000 in net losses against ordinary income per year
- Use tax-advantaged accounts — Investments in 401(k), IRA, and Roth IRA are not subject to capital gains tax while inside the account. Roth IRA gains are never taxed
- Gift appreciated stock — Gifting stock to family members in lower tax brackets can result in 0% capital gains tax for them
- Donate appreciated stock — Donating stock directly to charity avoids capital gains tax entirely AND gives you a charitable deduction for the full market value
- Step-up in basis at death — Inherited investments get a stepped-up cost basis to the value at date of death. All unrealized gains are erased. This is why selling and re-buying before death can be a mistake