Capital Gains Tax, Rates, and Impact
Is Investment Income Taxed Less Than Employment Income?
The capital gains tax is a government fee on the profit made from selling certain types of assets. These include stock investments or real estate property. A capital gain is calculated as the total sale price minus the original cost of an asset.
A capital loss occurs when you sell an asset for less than the original price. Some capital losses can be used to offset capital gains on your tax return, which lower the amount of taxes you pay.
The capital gains tax only becomes due once you sell your investment. For example, you won't owe any tax while a stock gains value inside your portfolio. However, once you sell your shares, the profit must be reported on your tax return. As a result, you pay a tax on your profit at the capital gains rate.
Short-Term vs. Long-Term Capital Gains
The federal government taxes all capital gains. Short-term capital gains or losses occur when you've owned an asset for a year or less. Long-term capital gains or losses occur if you sell an asset after owning it for longer than one year.
Short-term capital gains have a higher tax rate than long-term capital gains. This is deliberate to discourage short-term trading. Trading stocks and other assets frequently can increase market volatility and risk. It also costs more in transaction fees to individual investors.
Standard Tax Rates
There are two standard capital tax rates for long- and short-term investments:
- Short-term capital gains tax rate: All short-term capital gains are taxed at your regular income tax rate. From a tax perspective, it usually makes sense to hold onto investments for more than a year.
- Long-term capital gains tax rate: The tax rate paid on most capital gains depends on the income tax bracket. Those in the 10% and 12% income tax brackets generally pay zero capital gains tax.
Those in the top income bracket pay 20%. For 2017, the top tax bracket was 39.6%. The Tax Cuts and Jobs Act changed the top income tax rate to 37% for the 2018-2025 tax years.
The TCJA also decoupled capital gains tax brackets and ordinary income tax brackets. Here are the capital gains tax brackets by income for 2019:
|For Unmarried Individuals||For Married Individuals Filing Joint Returns||For Heads of Households|
Source: Tax Foundation
Long-term capital gains on collectibles, such as stamps, coins, and precious metals, are taxed at 28%.
Taxpayers can declare capital losses on financial assets, such as mutual funds, stocks, or bonds. They can also declare losses on hard assets if they weren't for personal use. These include real estate, precious metals, or collectibles. Capital losses, either short- or long-term, can offset short- and long-term gains.
If you have long-term gains in excess of your long-term losses, you have a net capital gain. However, if you have a net long-term capital gain, but it's less than your net short-term capital loss, you can use the short-term loss to offset your long-term gain.
You can use net capital gain losses to offset other income such as wages.
But that's only up to an annual limit of $3,000, or $1,500 for those married filing separately. What happens if your total net capital loss exceeds the yearly limit on capital loss deductions? If you can't apply all of your loss in one tax year, you can carry the unused part forward to the next tax year.
How It Affects the Economy
Based on past studies, 70% of capital gains go to people in the top 1% of income. Everyone else keeps their assets in tax-deferred accounts such as 401(k)s and IRAs. This creates a tax benefit for the top 1%. Those who live off of investment income never pay more than 20% in taxes, unless they take income from assets held for less than one year. This applies even to hedge fund managers and others on Wall Street who derive 100% of their income from their investments.
In other words, these individuals pay a lower income tax rate than someone making $40,000 a year.
This has two outcomes:
- It encourages investment in the stock market, real estate, and other assets, which generates business growth.
- It creates more income inequality. People who live off of investment income already fall into the wealthy category. They've had enough disposable income in their life to set aside for investments that generate a healthy return. In other words, they didn't have to use all their income to pay for food, shelter, and healthcare.
The Tax Cuts and Jobs Act puts more people into the 20% long-term capital gains tax bracket. This is achieved when the IRS adjusts the income tax brackets each year to compensate for inflation. But they will rise more slowly than in the past. The Act switched to the chained consumer price index. Over time, that will move more people into higher tax brackets.
Capital Gains Tax Rate History
The long-term capital gains tax rate hasn't always been the same. The following table shows the history for the capital gains tax rate applied to income in the highest tax bracket:
|1913||15%||Before 1913, 90% of all revenue came from alcohol and cigarette taxes.|
|1922||12.5%||Tax cut led to the stock market crash.|
|1936||39%||Hike revived depression.|
|1942||25%||Revenue Act of 1942.|
|1979||28%||Cut to offset high-interest rates.|
|1982||20%||Recovery Act of 1981.|
|1987||28%||Tax Reform Act of 1986 reduced the income tax to 28% from 50%.|
|1998||21.19%||Clinton lowered it to expand the EITC.|
|2013||20%||Obamacare taxes add a 3.8% tax on some long-term capital gains for those whose income exceeds $200,000 a year.|
Source: Tax Foundation