Debunking the Myths Around Capital Gains Taxes

Stack of money on timeline chart

You’ve invested $50,000 in stocks from a taxable trade account from E-Trade, for example’s sake, and you’ve had a great few years. You’ve made $25,000, so your new E-Trade balance is $75,000 a couple of years later. When tax time comes around, will you have to have to pay capital gains taxes on the entire $75,000 sitting in your trade account?

The layperson’s understanding of taxes on investment income says yes, but like a lot of common knowledge surrounding the complex US tax code, that’s not actually how capital gains taxes work.

Take a look at how taxes on investment portfolio growth and income really work and get a better understanding of capital gains taxes.

How Taxes on Investment Portfolio Growth and Income Really Work

A capital gains tax is, put simply, the tax on the profits you gain from selling assets such as stocks, bonds, real estate, or property. Where people get confused is that they conflate the growth of their investment portfolio with the total value of their investment and think the US’s capital gains tax rate of 15% applies to the entire worth of their investment.

You see, it’s called capital gains taxes for a reason—the only monies you are actually taxed on are the gains you’ve made from your investment. What does this look like in practice? Let’s go back to the example we started out with.

You invested $50,000 and the worth of your investments has increased to $75,000. The current capital gains tax rate is 15%, and it only applies to the difference between $75,000 and $50,000. In other words, you’ll only owe $3,750 in capital gains taxes, because your actual investment income is $25,000—not 25% of the entire $75,000 in your account.

Let’s delve into another popular misconception about taxes on investment portfolio growth and income. Many people are afraid of capital gains taxes and seek means to minimize or avoid them at all costs because they’re worried they have to pay taxes every year based on the value of their investments on December 31 of the prior year.

Fortunately, that’s not true, either! Using the example of stocks as the investment medium, you’ll only pay taxes on the stocks when you sell those stocks for a gain. Remember, you don’t really gain income from stocks or other non-inventory assets until you actually sell them—until you do, a stock is really just potential income.

Understanding Long-Term vs. Short-Term Capital Gains Tax

As a little bonus tip, any stocks sold for a gain that you’ve held for less than a year are taxed at your normal income tax rate rather than the capital gains rate of 15% if your income falls in the 25% tax bracket or higher or only 5% if your income is in the 15% tax bracket or lower. This is the difference between long-term and short-term capital gains taxation. If you sell an investment that you’ve held for one year or less, any gain is considered a short-term capital gain and is taxed at your ordinary income tax rates, which can range from 10% to 37% depending on your taxable income.

On the other hand, if you sell an investment that you’ve held for more than one year, any gain is considered a long-term capital gain and is taxed at a much lower rate.

Understanding Other Tax Implications of Investment Gains

The capital gains tax is just one example of the ways your investment gains influence your tax status. Other tax implications of your investment gains include:

  • Qualified dividends from domestic corporations are taxed at long-term capital gains rates.
  • Non-qualified dividends are taxed at ordinary income rates.
  • Interest earned from investments such as bonds, savings accounts, and CDs are generally taxed as ordinary income.
  • Investments in tax-deferred accounts such as traditional IRAs and 401(k)s grow tax-free until you start withdrawing funds.
  • Investments in tax-exempt accounts grow tax-free, and qualified withdrawals are also tax-free.
  • Capital losses can offset capital gains, and if your losses exceed your gains, you may be able to deduct the losses from your other income.
  • In addition to federal taxes, you may also owe state taxes on your investment gains, depending on the state you live in. For example, in Georgia, capital gains are taxed the same as any other income.

It isn’t surprising that so many misconceptions exist about how capital gains taxes work—and unfortunately, misunderstanding the tax implications of investment gains or misusing strategies to avoid or minimize taxes on investment portfolio growth can land you in hot water with the IRS or state revenue agencies.

If you’ve found yourself in tax trouble due to issues with capital gains taxes, call the tax attorneys at Wiggam Law for a free consultation. We’ll help you overcome your tax issues and get your life back on track.