Capital gains tax generally applies when you sell an investment or asset for more than what you paid for it. In other words, all profits from the sale are considered taxable in the eyes of the Internal Revenue Service. Whether you pay the tax rate on short-term capital gains or long-term capital gains depends on how long you held the investment before selling it. Short-term capital gains are subject to ordinary tax rates, which are set by law and controlled by the IRS.
The tax code can be confusing, which is why working with a financial advisor to make sure you’re not overpaying makes perfect sense.
What is the short-term capital gains tax?
Short-term capital gains tax is a tax on gains from the sale of assets that you have held for a year or less. Short-term capital gains tax is generally applied to the sale of securities, including stocks and mutual funds. But it is also possible to be taxed on short-term capital gains on the sale of other assets, such as real estate, vehicles or collectibles.
Suppose you want to flip houses for profit, for example. You buy a house, invest the money to fix it, and then sell it for a profit of $ 40,000 six months later. If you’ve owned the home for a year or less, you may owe short-term capital gains tax on the proceeds from the sale. The same can be true if you buy and sell vintage cars as a hobby or sideline.
So why is there a capital gains tax? A simple reason. The IRS assesses capital gains tax as a means of generating income for the government. These revenues are then used to fund government programs and spending.
Short-term capital gains tax rate 2021
The IRS uses regular tax rates to tax capital gains. This means that the tax on investments you sell in the short term would be determined by your tax bracket. Your tax bracket is based on your income and your reporting status. Here’s how the short-term capital gains tax rates for 2021 compare by filing status.
Short-term capital gains tax rate 2021 rate Single filers Married couples jointly filing Head of household 10% Up to $ 9,950 Up to $ 19,900 Up to $ 19,900 12% $ 9,951 to 40,525 $ 19,901 to $ 81,050 $ 14,201 to $ 54,200 22% $ 40,526 to $ 86,375 $ 81,051 to $ 172,750 $ 54,201 $ 86,350 24% $ 86,376 to $ 164,925 $ 172,751 to $ 329,850 $ 86,351 to $ 164,900 32% $ 164,926 to $ 209,425 $ 329,851 to $ 418,850 $ 164,901 to $ 209,400 35% $ 209,426 to $ 523,600 $ 418,851 to $ 628,300 209 $ 301 or more
Any short-term gains you realize are included with your other sources of income for the year for tax purposes. So if you have $ 20,000 in short-term earnings and earn $ 100,000 in wages from your day job, the IRS considers your total taxable income to be $ 120,000.
It is important to remember that the United States uses a progressive tax system. This means that the same regular tax rate may not apply to your total income for the year if it includes short-term capital gains. If you have earned working income as well as short-term capital gains from the sale of investments, there may be more than one tax rate applied to determine what you owe.
In addition to the federal short-term capital gains tax, you can also pay state-level capital gains taxes. Where you live can determine whether you are subject to short-term capital gains tax and whether you will pay a rate equal to or lower than your regular tax rate.
Short-term or long-term capital gains tax
The long-term capital gains tax rate applies to investments that you sell for a profit after holding them for more than a year. Between the short-term and long-term capital gains tax rate, the long-term rate is more favorable to investors. This is because it is unrelated to your regular tax bracket. This is what the long-term capital gains tax rate looks like for 2021.
Long-term capital gains tax rate 2021 rate Single tax filers, higher taxable income than married couples filing jointly, higher taxable income for heads of household, taxable income greater than 0% $ 0 $ 0 $ 0 15% 40 $ 400 80 $ 800 54 $ 100 20% 445,850 501 $ 600 $ 473,750
As you can see, long-term capital gains tax rates are generally lower than short-term capital gains tax. And for some taxpayers, there may be no capital gains tax associated with the sale of investment securities or other assets.
How to minimize short-term capital gains tax
Which tax bracket you land in is determined by your income and reporting status. But it is possible to minimize your tax on short-term capital gains. Here are some options you might want to consider to lower your investment tax bill:
Keep your investments longer. Avoiding the short-term capital gains tax rate can be as simple as holding investments for more than a year. Whether this is realistic for you or not may depend on whether you are an active day trader or prefer a buy and hold approach to building a portfolio.
Crop losses. Harvesting tax losses allows you to offset capital gains by selling some of your investments at a loss. This is a strategy that you can apply in a taxable brokerage account. Although it is possible that the losses will be harvested automatically if you use a robo-advisor to invest.
Consider the location of assets. Asset allocation is important in creating a diversified portfolio, but the location of assets is important from a tax perspective. Capital gains tax only applies to investments held in taxable brokerage accounts. So you can benefit from keeping some of your assets in a tax-efficient account, such as a 401 (k) or IRA.
Reinvest dividends. Dividend reinvestment allows you to buy additional stocks without investing money out of pocket. If you have dividend paying stocks, consider reinvesting the dividends to strengthen your portfolio so that you are less tempted to sell your winners. Keep in mind, however, that dividends are still taxable even if they are reinvested.
Your financial advisor or tax preparer may be able to offer you additional solutions or advice on how to manage your investment tax liability. And it’s also important to remember that investment taxes are part of the puzzle. Claiming tax credits or deductions could help put you in a lower tax bracket, which can mean paying less capital gains tax. For example, you may be able to deduct certain investment interest expenses when you file your taxes. Deductions reduce your taxable income while credits reduce your tax payable.
The bottom line
Paying capital gains tax may be unavoidable in some scenarios, but there are things you can do to minimize what you will pay for short-term gains. Creating a tax-diversified investment strategy can help you keep more of your earnings over time.
Tips for investing
If you’re just starting to invest, it’s important to manage fees while you manage taxes, as fees can eat away at overall returns. Choosing the right broker can help. More and more online brokerage houses are now offering commission-free transactions for US stocks and exchange-traded funds (ETFs). Finding brokerage firms can help you find the one that offers the best combination of investment options, features, and costs to meet your needs.
Consider speaking with a financial advisor about the best way to manage short-term investments and the associated gains. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is best for you. If you’re ready to find an advisor, start now.
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The publication Short-Term Capital Gains Tax Rates for 2021 first appeared on the SmartAsset blog.