There are several new tax laws and provisions to be aware of as we head into 2013 tax season, but one of the most important ones is the change that is taking place when it comes to capital gains tax rates.
Due to new fiscal cliff legislation, capital gains & dividend tax rates are increasing from 15% to 20% for singles earning over $400,000 and couples earnings over $450,000. Additional changes include:
- Individuals making in the $36,250 to $400,000 range will see their capital gains continue to be taxed at a 15% tax rate. Meanwhile, earners in the lowest two income tax brackets will pay 0% on investment income.
- There will also be an additional 3.8% investment income tax applied to singles earning over $200k and couples earning over $250k. The purpose of this new tax is to help fund Medicare.
How To Minimize Capital Gains Taxes
Capital gains taxes can be minimizes in two major ways: by investing for a long time – and a very long time. If you invest for over a year, your capital gains become “long-term” rather than “short-term” and are taxed at the lower long-term capital gains rate. Short-term capital gains are typically taxed at the higher short-term rate. If you really want to minimizing taxes, invest for the very long term in assets with low dividend yields. Taxes are incurred when assets are sold or dividends are received, so by holding an asset for many years and minimizing dividends you are effectively deferring taxes for many years. By deferring taxes, your investment is able to compound more quickly, just as it would in a tax-advantaged account like an IRA or 401(k).
This tax-minimization strategy requires holding positions for long periods. To do so, you’ll want an investment account with a brokerage that will be around for a long time. You will also want to have access to quality fundamental company research so that you can invest carefully up front, since changes later will incur taxes. NerdWallet recommends the following brokers because of their long-established reputation and their access to the highest quality research:
- TD Ameritrade - With over 5 million customers, TD Ameritrade is one of the best established brokerages in the country. The company is know for customer service and access to top tier research. Stock trades cost $9.95 and the company provides free access to over 2,500 no-transaction-fee mutual funds.
- E*trade - With almost 3 million customers and over 20 years in business, E*trade has built a reputation for excellence in trading platforms. The company offers over 1,300 no transaction fee mutual funds, $9.99 trades, and free access to fundamental company research.
What Are Capital Gains?
The IRS defines capital gains and losses as such:
“Almost everything you own and use for personal or investment purposes is a capital asset. Examples include a home, personal use items like household furnishings, and stocks or bonds held as investments. When a capital asset is sold, the difference between the basis in the asset and the amount it is sold for is a capital gain or a capital loss.”
Put simply, the money you make on any investment is your capital gain – while any money you lost would be your capital loss.
In terms of the tax paperwork needed to file in 2013, the IRS further explains:
“Capital gains and deductible capital losses are reported on Form 1040, Schedule D (PDF), Capital Gains and Losses, and on Form 8949 (PDF), Sales and other Dispositions of Capital Assets. If you have a net capital gain, that gain may be taxed at a lower tax rate than your ordinary income tax rates.”
There are many exceptions to these general guidelines, so always be sure to consult a certified tax professional for any specific advice.
Why Are Your Investments Taxed?
Almost all countries tax capital gains to provide an additional source of national revenue. In the U.S., most capital gains are taxable by the IRS, giving the government a portion of any profits you make when you successfully invest. Though it varies widely by country, in the U.S. our net annual capital gains are what get taxed, as well as dividends.
This is one of the reasons that an individual retirement account (IRA) is such an appealing option for investors saving for retirement; they can invest money in a tax-advantaged account such that the profits they earn over time become tax free during their life time. While the details vary by the type of tax-advantaged account you select, these are on the whole a very effective money management strategy because your money avoids high tax rates as it grows.
What If Your Investments Lost Money This Year?
Worried about how to file if your investments lost money this year? Don’t fear – you can use your capital losses to offset your gains, thereby potentially affecting the rate at which you are taxed. If you sold your investment at less than the purchase price you paid for it, you may be eligible here.
For more details on how the new tax rates apply to you, visit NerdWallet’s comprehensive guide to 2013 investment tax rates.