When you make money on an investment, it is called a capital gain.
Here in the U.S., we are taxed on capital gains.
It is worth noting, though, that you aren’t taxed on the gain until you actually realize it. That is, you aren’t taxed until you sell and the investment earnings are yours.
When you sell makes a difference in how you are taxed. There is a tax advantage to holding on to an investment for a longer period of time, since the tax rate on long term capital gains is usually lower than what you would find on short term capital gains.
Let’s look at the differences between short term vs long term capital gains.
Long Term Capital Gains Tax
Whether or not your investment gain is taxed as long term or short term depends on how long you have held it. In order to qualify as a long term investment, you need to hold the investment for more than one year. This means that you need to have the investment for at least one year and one day for it to qualify.
Your “tax bracket” for long term capital gains is based on your marginal tax bracket. Right now, the lowest tax rate on capital gains right now is 0%. This is a temporary situation for capital gains taxes. If you are in the 10% or 15% tax bracket (this is total income, including your capital gains), you don’t owe anything extra for capital gains taxes.
If you are higher than those tax brackets, you will owe 15% in capital gains taxes. Even though this tax rate was extended, it could expire if Congress doesn’t change things. But, for 2011, you can potentially avoid paying long term capital gains taxes.
However, even with a shift in the way long term capital gains are figured, the top rate is likely to be no more than 20% or 25% over time.
Short Term Capital Gains Tax
By contrast, there is no special tax rate for short term capital gains. If you hold an investment for a year or less, you will be taxed at your regular income rate. If income tax rates go up, or if your capital gains bump you into another tax bracket, you will pay whatever income tax is “normal” for you.
As you can see, if you are in a higher income tax bracket, it might make sense to hold on to your investments until they qualify as long term. That way, part of your income would be taxed at a lower rate.
Tax on Collectibles
You should be aware that there are different rules for collectible assets. While you might consider them investments, the IRS looks at them as a different class, “collectible assets.” If you hold collectibles for a year or less, and then sell, you are taxed at your marginal rate.
However, if you hold collectible assets for more than a year, you will be taxed at a 28% rate. For those in lower tax brackets, holding collectibles for a long time can actually be detrimental when it comes to tax liability.
Part of your investment planning should include considering the tax ramifications associated with when you sell your investments.