Trillionaire Term of the Day - January 13, 2009

Capital Gains Tax

When there is a way to make money, there is also a way for the government to tax you. This idea carries over into your gains from investing. The Capital Gains Tax (CGT) taxes the money you make when you sell a capital asset for a price higher than what you bought it at. Examples of capital assets include: stocks, bonds, precious metals, and property.

The CGT only taxes your realized net gains for the year. Basically, you take your realized gains and subtract your realized losses, and you are taxed on what remains. By “realized gains/losses”, I am trying to imply that you are only taxed on stocks that you sell. Your investments can continue to increase in your portfolio, but you won’t be taxed until you choose to sell them.

Let me create an example to help illustrate this. You buy 200 shares of Company A at $10 a share in January 2009. You buy 100 shares of Company B at $10 a share in January 2009. By November 2009, Company A’s shares have risen to $20 dollars and you sell all of them. This sale of capital assets gives you a realized gain of $2000 [(200 X $20) – (200 X $10)]. By November 2009, Company B’s shares are worth $5 and you sell all of them. This sale gives you a realized loss of $500 [(100 X $10) – (100 X $5)]. Your tax won’t be calculated until the end of the year. Your realized net gain (the amount that will be taxed) for this hypothetical scenario would be $1500 ($2000 - $500). If the CGT at the time was 15%, then you would be taxed $225 ($1500 X .15) and be left with $1275.

The Capital Gains Tax varies from year to year in percentage, but it is always based on your income tax bracket. The percentage of the tax also depends on whether your gains come from Short-term investments or Long-term investments. Short-term investments are investments that last a year or less (between the date of buying and selling). These investments are simply taxed at the same percentage of your income tax bracket. Long-term investments are held at least a year (between buying and selling) and are taxed at a lower rate than Short-term investments. As of right now, the Long-term investment CGT is at 15% for the top 4 income tax brackets and 0% for the bottom 2 income tax bracket. These rates came into effect in 2003 and will last until 2010 because of George Bush’s Tax Reconciliation Act.

While it may be dissatisfying to know that you will be losing a portion of your gains from investing, you should never let the CGT discourage you from making a move in the markets. You will be taxed less money on your capital gains than you will be taxed on the income that you create from your job. So, keep investing!

-Matt Schwartz
College Trillionaire