So what are Capital Gains?

When you sell an asset for more than you paid for it, your profits are considered capital gains.

This is a different type of income than what your regular job pays, which would be considered earned income.

A crucial difference between these two types of income is how they are taxed, and capital gains have a much more favorable tax treatment.

How are Capital Gains Taxed?

In two ways, depending on how the gain was earned. If you sold the asset without owning it for a year you are on the hook for short-term capital gains which are taxed at your normal tax rate, easily somewhere in the 20-30% range.

If you held onto the asset for more than 12 months, your profits are considered long-term capital gains and given preferable tax treatment.

In 2022, if you make up to $41,675 a year, you pay 0% on long-term capital gains.

If you make up to $459,750 a year, you pay 15% tax on long-term capital gains.

And if you make more than $459,750 a year, you pay a 20% tax on capital gains.

How does this affect my taxes?

Let's use an example. An investor buys $10,000 worth of stocks and sells them for $20,000 in 6 months. This means they made $10,000 in profit and it's considered short-term capital gains. If the investor has a $90k salary they are in the 24% federal tax bracket and would owe 24% of their $10,000 gain in taxes. Leaving them with $7,600 at the end of the day.

If the same investor were to hold on to those stocks and sell them after a year, things would change.

The investor sells their stock for a $10,000 profit after 12 months, so their profits are considered long-term capital gains. Based on their tax bracket, they would owe 15% which would leave them with $8,500 after taxes. That's $900 more in profit (+11.8%) than taking short-term capital gains.

Closing Thoughts

Capitals gains let investors profit in a tax-advantaged way, which can leave you with a much smaller tax bill than the earned income you get from your job. It's another way the wealthy get wealthier, but it's also a strategy that any investor (including you) can and should consider.

By the way, I'm not a financial professional and none of this should be considered financial advice. Please consult with your financial advisor when considering any suggestions or ideas I've shared.