I don’t need to tell you that taxes are a big fucking deal. They can make a huge difference in making or breaking your wealth. Let’s say you made a million bucks last year. How much would you be left with after taxes? This is essentially capital gains – a type of tax after the sale of an asset. Let’s break it down even further though.
Short Term Vs. Long Term
There are two types of capital gains taxes: short-term and long-term. Both are taxes but triggered after different periods of time and have different rates. Short-term capital gains apply when you sell an investment before a year is up. Today the rates are currently the same as ordinary income tax. Long-term capital gains, on the other hand, are taxes you pay on investments you hang onto for a year or longer. The tax rate for those gains is much lower than short-term capital gains, as they are taxed at 20% for the highest earners and 0% for the lowest earners. Wherever possible, when you do sell investments, try to do so after a year so you are taxed at a much lower rate.
Why does this matter? Well I’ll tell you. If you happen to lose money on your investments, then the short-term losses can be used to offset the short-term gains. The long-term losses can also be used to offset the long-term gains. So, if you lose $1,000 and earn $2,500 in the short term, you would be taxed $1,500 because the $1,000 offsets the $2,500. But let’s say you also had $1,500 of long-term losses; that can also be used against the $2,500, giving you a net taxable gain of 0.
Mastering Capital Gains
There are three ways to master capital gains. The first is that wherever possible, keep higher cost investments (like mutual funds) growing inside tax-deferred accounts like a 401(k), IRA, etc. so that you’re letting it compound in a tax-free environment (future tax-free environment in the case of Roths). Second, try not to have mutual funds outside of vehicles like the ones I just mentioned because even if you’re not selling the fund, the folks managing it are a lot and you’re hit with the bill for all that movement without even selling it yourself. Finally, if you do have any investment, including a mutual fund, outside of retirement or annuity vehicles, hang onto them for more than a year.
Here’s a tip you can take straight to the bank: the more you lower your rate of return, the longer it will take for you to double your money. So do everything you can to bump up your rate of return and be thoughtful about your taxes. Always make sure to consider capital gains before you sell!