Understanding when to pay capital gains tax is important for both individual investors and businesses. This tax is applied to the profit, or capital gain, made from selling assets like stocks, bonds, property and precious metals. It is generally paid when your taxes are filed for the given tax year, not immediately upon selling an asset. Working with a financial advisor can help optimize your investment portfolio to minimize capital gains tax.
How Capital Gains Tax Works
Capital gains tax is calculated by subtracting the cost basis (generally the original purchase price of the asset) from the selling price. The resulting profit is what generally gets taxed, but it’s not always that simple. There are things you can do to cut down on your capital gains tax obligation, including how long you hold that asset. This calculation is an essential part of asset management and understanding it can help you plan your finances better.
It’s important to acknowledge the distinction between short-term and long-term capital gains. Short-term capital gains refer to profits from assets held for one year or less and are taxed at a higher rate. Long-term gains, on the other hand, result from assets held for more than one year and are frequently taxed at lower rates. However, these rates should not imply that long-term gains are always superior. The reality is that different investment strategies tend to prioritize different timelines.
When You Might Owe Capital Gains Tax
Several scenarios may trigger capital gains tax liabilities, but the tax is generally applied when you sell some type of investment.
For example, making a profit by selling real estate (primary residences can be exempt periodically and capped), stocks, bonds and collectibles, could result in owing capital gain tax.
Moreover, if you sell inherited assets for more than their fair market value at the time of the decedent’s death, this too can lead to a capital gains tax liability.
When Capital Gains Tax Is Paid
Capital gains tax is typically reported and paid when you file your federal income tax return, due in April each year for individuals.
There aren’t any rules that require you to pay what you owe at the time you sell the asset. However, encountering a situation where you expect to owe more than $1,000 in taxes could require you to make estimated tax payments throughout the year.
Planning ahead could help you avoid penalties and interest.
Capital Gains Tax Rates 2023
For 2023, the long-term capital gains tax rates come in at 0%, 15% and 20%, depending on your income level.
This tiered strategy requires that individuals with higher incomes pay more capital gains tax than those with a lower income bracket. The amount that you pay will depend on your tax filing status and where you fit into those tiers.
Take note: Tax rates for short-term capital gains will also depend on your current tax bracket, which also factors in your filing status.
Exceptions to Capital Gains Tax
There are several exceptions to capital gains tax that, if leveraged correctly, can help reduce your tax liability considerably.
For instance, selling your primary residence can exclude up to $250,000 of your capital gain from tax ($500,000 for married couples), under certain conditions.
Inherited assets are another exception. These can qualify for a step-up in basis to their fair market value at the time of the original owner’s passing. And this could reduce your capital gains tax when selling those assets.
How to Minimize Capital Gains Tax
While capital gains tax can be a significant cost, there are several strategies to legally minimize it.
Investing through tax-sheltered accounts like an IRA or a 401(k) can be one option. These accounts allow for tax-free or tax-deferred growth of your investments, providing substantial tax savings over time.
Holding onto investments for longer than one year is another strategy. This could qualify you for a lower long-term capital gains tax rate.
Keep in mind that these strategies carry both benefits and drawbacks. Choosing the strategy that aligns best with your goals will largely depend on your finances.
Bottom Line
Understanding your tax obligation, especially as an investor, can be vital to helping you maximize your potential return. The capital gains tax gets applied to profit made from the sale of stocks, bonds, property and other assets. You generally pay it when you file your taxes. But owing a substantial amount could require you to make estimated payments throughout the year.
Tips for Tax Planning
- An experienced financial advisor who specializes in tax planning can help you maximize all of your investments and limit your tax obligations across your portfolio. They can also help you manage that portfolio to maximize results. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- You can use a free income tax calculator to help you estimate what taxes you might owe in any given year, based on your unique situation.
Photo credit: ©iStock.com/Pekic, ©iStock.com/Wavebreakmedia, ©iStock.com/Pekic