Capital gains fall into a category of income called unearned income. This separates them from income that people earn at their job (i.e., wages). Because of this difference, capital gains may be taxed differently from earned income. In this article, we’ll look at how capital gains are taxed and who has to pay them.
Who Pays Capital Gains Tax?
The IRS requires anyone who sells an investment that earns a capital gain to pay a capital gains tax. A capital gain refers to the profit realized on an asset, such as an investment property, when you sell it for more than its adjusted cost basis (its material value is based on changes that occurred when you owned the asset).
You only have to pay capital gains on the sale of investments like stocks, bonds, and real estate. If you receive an asset as an inheritance or gift, you do not have to pay capital gains until you decide to sell it.
At the time of sale, the asset’s basis will be determined by the fair market value at the time of the benefactor’s death, possibly reducing your capital gains liability.
How Much Tax Do You Pay On Capital Gains?
Capital gains taxes come in two flavors —short and long-term. Short-term gains are taxed at your ordinary income tax rate. Long-term gains are taxed at a lower rate. For 2022, the rates are:
Tax Rate | Filing Single | Married Filing Joint Returns | Married Filing Separately | Head Of Household |
0% | $0-$41,675 | $0-$83,350 | $0-$41,675 | $0-$55,800 |
15% | $41,675 – $459,750 | $83,350 – $517,200 | $41,675 – $258,600 | $55,800 – $488,500 |
20% | Over $459,750 | Over $517,200 | Over $258,600 | Over $488,500 |
Do You Pay State Tax On Capital Gains?
Not all states have an income tax. But those that do will tax capital gains at the ordinary state income tax rate. States such as New Hampshire and Tennessee don't have an income tax but do tax dividends and interest.
Are Capital Gains Included In Taxable Income?
We hinted at this in the introduction. Income is broken down into earned and unearned income. Both are taxable, but long-term capital gains are taxed at a different rate whereas earned income and short-term unearned income are taxed at the same rate. This means capital assets sold for a gain before they were held for a year will be taxed at your ordinary income rate.
Do You Pay Capital Gains On 401(k)?
No —gains in a 401(k) account grow tax-deferred until they are withdrawn. At that point, you’ll pay the ordinary income tax rate on any distributions. This includes federal and state/local taxes where applicable. Keep in mind that you’ve already paid FICA taxes (i.e., Social Security and Medicare), so you won’t have to pay those again.
While you’ll pay taxes on 401(k) distributions during retirement, if your income is lower than it was during your working years, it’s possible the income tax on your distributions will also be lower. We say “possible” because no one can know what tax rates will be years into the future.
Do Capital Gains Affect Your Social Security Benefits?
Yes —capital gains can certainly affect your social security benefits. Whether or not social security is taxed will depend on your “provisional income.” If you end up paying taxes on your social security because of capital gains, don’t worry, you won’t be alone. About one-third of benefit recipients pay federal taxes, according to the Social Security Administration, as noted by AARP.
The following formula can help you figure out your provisional income:
50% of Social Security Benefits Received
+ Additional Income
= Total Provisional Income
Additional income includes wages, self-employment income, pension benefit, interest earned (taxable and nontaxable), dividends received, and other taxable income. Capital gains will fall into the additional income category as well.
With provisional income calculated, compare it to the following income limits to determine if you need to pay taxes:
- Single filers with provisional income of $25,000 to $34,000 must pay income tax on up to 50% of their Social Security benefits. If provisional income exceeds $34,000, single filers can be liable to pay taxes on up to 85% of these benefits.
- If you are married filing jointly, you can be liable for income taxes on up to 50% of your Social Security benefits if your joint income is between $32,000 to $44,000. If joint income is above $44,000, you can be liable for taxes on up to 85% of your Social Security benefits.
Figuring out the exact amount of taxes you’ll pay on social security can get complex. Instead of trying to do it on your own, it’s best to work with your tax professional.
How To Offset Capital Gains?
There are several ways to reduce your capital gains. Here are five.
Capital losses —selling capital assets that have lost value can be used to offset gains. This practice is known as “tax-loss harvesting” and can be used for both short-term losses and gains, as well as long-term losses and gains. The IRS also allows taxpayers to write-off as much as $3,000 of taxable income per year from capital losses, while also allowing excess losses to be carried forward to future tax years.
Step-up basis —gifting property to an heir will require them to take on your basis. If your basis from 15 years ago was $200,000 and the market value now is $400,000, your heir will have to pay $200,000 in capital gain taxes if they chose to sell the asset immediately. However, if the heir inherits the property, their basis will be that of the current fair market value. In this case, $400,000, which avoids the large capital gains tax bill.
Personal residence exclusion —you can exclude up to $250,000 or $500,000 if married on the sale of your personal residence if you’ve lived in it for two out of the last five years. These two years don’t have to be consecutive.
1031 exchange —rolling gains from the sale of a property into a 1031 exchange can defer taxes for years to come. There are specific rules and deadlines to follow, but these transactions are generally straight-forward.
Hold for the long-term — selling an investment within one year will result in short-term capital gains taxes, which is the same as your ordinary income tax rate. If possible, holding for more than a year can significantly reduce your tax bill on gains, as you’ll be paying long-term instead of short-term rates.
With a little planning, you can reduce taxes on your investments. Working with a tax professional and financial advisor is critical to successfully executing this plan.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not offer legal or tax advice. As such, this information should not be used as a substitute for consultation with professional accounting, tax, legal or other competent advisers. Before making any decision or taking any action, you should consult with a qualified professional.
As a financial expert with a deep understanding of taxation and investment strategies, I can confidently delve into the concepts discussed in the article about capital gains. My expertise stems from years of professional experience in the field, backed by a robust understanding of tax regulations, financial planning, and investment management.
Let's break down the key concepts discussed in the article:
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Capital Gains and Unearned Income:
- Capital gains fall into the category of unearned income, distinguishing them from earned income such as wages.
- Unearned income, including capital gains, may be subject to different tax treatment than earned income.
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Who Pays Capital Gains Tax:
- The IRS requires individuals to pay capital gains tax when they sell an investment that has earned a capital gain.
- Capital gain is the profit realized on an asset when sold for more than its adjusted cost basis.
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Types of Investments Subject to Capital Gains Tax:
- Capital gains tax applies to the sale of investments like stocks, bonds, and real estate.
- No capital gains tax is incurred when receiving an asset as an inheritance or gift until it is sold.
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Tax Rates on Capital Gains:
- Capital gains taxes come in two forms: short-term and long-term.
- Short-term gains are taxed at ordinary income tax rates, while long-term gains have lower tax rates.
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State Tax on Capital Gains:
- States with income tax may tax capital gains at the ordinary state income tax rate.
- States without income tax, like New Hampshire and Tennessee, may still tax dividends and interest.
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Inclusion of Capital Gains in Taxable Income:
- Income is categorized as earned or unearned, with long-term capital gains taxed differently from short-term gains and earned income.
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Capital Gains and 401(k):
- Gains in a 401(k) account grow tax-deferred until withdrawal, at which point ordinary income tax rates apply.
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Impact of Capital Gains on Social Security Benefits:
- Capital gains can affect Social Security benefits, with taxation depending on provisional income.
- Provisional income includes 50% of Social Security benefits and additional income, including capital gains.
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Ways to Offset Capital Gains:
- Strategies to reduce capital gains include tax-loss harvesting, step-up basis, personal residence exclusion, 1031 exchange, and holding investments for the long term.
- Collaboration with tax professionals and financial advisors is crucial for successful tax planning.
In conclusion, understanding the intricacies of capital gains taxation and employing effective strategies to offset tax liabilities requires careful consideration and expert guidance. The information provided in the article serves as a valuable guide for individuals seeking to navigate the complexities of capital gains and optimize their financial outcomes.
