One reason taxpayers tend to resent the IRS is that it takes a piece of our hard-earned money -- no matter where that money comes from. And while we're all used to paying taxes on our regular income, capital gains taxes -- those applied to investments sold at a profit -- can be a pretty harsh blow. But while you can't get out of paying taxes on your investment gains, you can take steps to lower the rate at which you're taxed, thus allowing you to keep more of that profit for yourself.
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Long-term capital gains are taxed more favorably
Holding assets for a longer period of time before selling them can make a huge difference in your overall tax bill. That's because the IRS taxes long-term capital gains at a lower rate than short-term gains.
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Long-term capital gains are those applied to investments held for at least a year and a day. Short-term capital gains, by contrast, are applied to investments held for one year or less. Short-term gains can really hurt investors because they're taxed as ordinary income.
Here's an example to illustrate the difference. Say you typically fall into the 25% tax bracket and make $5,000 on an investment. If you're looking at short-term capital gains, you'll lose $1,250 of your proceeds to taxes. But if you hold that investment long enough to qualify for the more favorable long-term capital gains tax rate, you'll lose just 15%, or $750.
The following table breaks down the current short-term capital gains structure, which mimics our present ordinary income tax brackets:
Data source: IRS.
With that in mind, here's what the current long-term capital gains tax structure looks like:
Data source: IRS.
As you can see, the majority of taxpayers lose 15% or less on investment gains when those assets are held for at least a year and a day. Even the country's wealthiest get a huge tax break -- 20% versus 39.6% -- for holding investments longer.
That said, some investors do pay slightly more taxes on capital gains. Single filers earning more than $200,000 and joint filers earning more than $250,000 are subject to a 3.8% net investment tax on investment income that exceeds these limits.
Will President Trump's tax plan impact capital gains?
President Trump has proposed a simplified tax plan that will cut the existing number of brackets down to only three. Here's what his proposal looks like:
Data source: DonaldJTrump.com.
If Trump's plan goes through, taxpayers will still get a sizable break for holding investments for at least a year and a day. Furthermore, under his proposal, the net investment tax imposed on higher earners will go away.
Strategic planning can pay off
If you're looking to lower your taxes, it pays to see whether you can get away with holding investments long enough to avoid the short-term capital gains tax rate. That said, it doesn't always pay to sacrifice profit for lower taxes.
Case in point: Say you have an opportunity to sell an investment at an $8,000 profit, but doing so will trigger a short-term gain at your 25% tax rate. Holding that investment another month will cut your tax rate down to 15%, but at that point, you'll be looking at half the profit. In this scenario, it pays to take a 25% tax hit on an $8,000 profit, because you'll still be left with $6,000 after all is said and done. While holding investments for at least a year and a day can help shave money off your tax bill, it doesn't always make sense to postpone the sale of an investment just to slash your taxes.
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