What Is Capital Gains Tax? Rates and How It Works (2024)

Vault’s Viewpoint

• Capital gains taxes apply to the profits—also known as capital gains—you earn when you sell certain assets.
• Capital gains are classified as either short-term or long-term, and long-term gains have a more favorable tax treatment.
• Ways to reduce your capital gains taxes include increasing your holding period, investing in tax-advantaged accounts and deducting your losses.

What Is a Capital Gain?

A capital gain is the difference between your adjusted basis in an asset and the price at which you sell it, assuming you sell it for a profit.

For example, if you sell an asset for $50 and your adjusted basis is $40, your capital gain is $10. In most cases, your adjusted basis in an asset is the price at which you purchased it, but there are some exceptions.

A capital gain can apply to any capital asset, including securities like stocks and bonds and physical assets like your home and its furnishings.

What Is the Capital Gains Tax?

The capital gains tax is a tax imposed by the federal government and many state governments on the profits earned from the sale of capital assets. This tax applies solely to your capital gain, meaning the difference between your adjusted basis and the sale price.

The amount of capital gains taxes you’ll pay on any given asset depends on several factors, including how long you held the asset before you sold it and your taxable income that year.

Short-Term vs. Long-Term Capital Gains

Capital gains are classified as either short-term or long-term gains. A short-term capital gain applies when you hold an asset for one year or less before you sell it. A long-term capital gain applies when you hold an asset for more than one year.

You can determine whether you have a short-term or long-term capital gain by counting from the day you purchased or acquired the asset. If you buy a share of stock on January 1 and sell it on January 1 of the following year, you have a short-term capital gain. But if you wait until January 2 to sell the asset, you have a long-term capital gain.

Long-term capital gains are taxed more favorably than short-term gains, so it’s usually beneficial to hold assets for more than one year before you sell them.

Capital Gains Tax Rates

The capital gains tax rate you’ll pay depends on two key factors: your taxable income and whether you have a short-term or long-term gain. Below you can see the tax rates for each type of capital gain.

Short-Term Capital Gains Tax Rates

Short-term capital gains are taxed like other income. The higher your overall taxable income, the higher the rate your capital gains will be taxed, with rates ranging from 10% to 37%.

The table below shows the short-term capital gains tax rates for each income range:

Long-Term Capital Gains Tax Rates

Long-term capital gains are taxed at lower rates than short-term gains. Rather than being taxed at the same rate as your earned income, long-term gains are taxed at special capital gains tax rates of either 0%, 15%, or 20%, depending on your income.

The table below shows the long-term capital gains tax rates for each income range:

Exceptions to Capital Gains Tax Rates

There are several assets that are taxed differently when they’re sold for a capital gain. First, a few assets may be taxed at rates higher than the typical 20% maximum long-term capital gains tax rate. The table below shows those assets, as well as their maximum capital gains tax rates:

Another exception to the standard capital gains tax rules applies to the sale of your home. When you sell your home, you won’t be taxed on the first $250,000 of your gain (or $500,000 for those married filing jointly) if you’ve owned the home and used it as your primary residence for at least two of the past five years.

How to Reduce Your Capital Gains Taxes

Capital gains taxes are often a necessary part of investing. But there are steps you can take to reduce your capital gains taxes and, in some cases, eliminate them altogether.

Invest in Tax-Advantaged Accounts

Capital gains taxes apply to assets in a taxable brokerage account, but the assets in your tax-advantaged retirement accounts are taxed a bit differently.

Retirement accounts such as 401(k) plans and individual retirement accounts (IRAs) have some key tax benefits, including deferred taxes. You won’t pay taxes on any capital gains, dividends, or interest on assets in your retirement accounts. In fact, you won’t pay any taxes at all until you withdraw money from your account, and then you’ll only pay income taxes.

Because assets in retirement accounts aren’t subject to taxes, you can reduce your capital gains taxes by holding your assets in these tax-advantaged accounts. And if you have money in both taxable and tax-advantaged accounts, you can reduce your tax liability by primarily selling assets in your tax-advantaged accounts when it’s time to rebalance your portfolio.

Hold Your Assets For More Than a Year

Since long-term capital gains are subject to significantly lower tax rates than short-term gains, one of the simplest ways to reduce your capital gains taxes is to hold all assets for more than one year before you sell them.

While some investors, including day traders, may find they need to sell assets more often, the average investor likely won’t have a problem holding most of their assets for more than a year.

When you sell assets from your investment portfolio, you can use a first-in-first-out approach. For example, let’s say you bought 10 shares of a particular stock 13 months ago and then another 10 shares six months later. If you sell 10 shares today, you should assume you’re selling the shares you purchased first. In this case, the first-in-first-out approach makes a considerable difference because it determines whether you’re subject to short-term or long-term capital gains.

Claim Your Investment Losses

Just as you must pay taxes on your capital gains, you can also claim a tax deduction for your capital losses. A capital loss occurs when you sell an asset for less than your adjusted basis.

You can use capital losses to offset your capital gains, therefore reducing the amount of taxes you owe. For example, if you sell one asset for a $1,000 gain and another for a $1,000 loss, the two would offset each other, and you would have no taxable capital gains.

You can also claim capital losses up to $3,000 in excess of your capital gains. For example, if you had $1,000 in capital gains and $5,000 in capital losses, you could claim $4,000 in capital losses—$1,000 to offset your capital gain and $3,000 in addition to that.

If your losses exceed your gains by more than $3,000, you can carry the remaining losses forward to offset your gains in future tax years.

This practice of offsetting capital gains with capital losses is often called tax-loss harvesting. When you use this strategy, you often intentionally sell an asset that’s lost money for the purpose of reducing your capital gains taxes.

If you use tax-loss harvesting to reduce your capital gains taxes, be sure not to violate the IRS’s wash sale rule. This rule prohibits you from selling a security for a loss and then repurchasing a substantially identical security within 30 days before or after the sale.