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The Ins-and-Outs of Capital Gains Tax Part I

How Much of That Juicy Pie Can You Keep?

Someone posted a comment asking me to explain capital gains tax. I did a little digging and found an excellent article on SmartMoney.com that sums up the different capital gains tax rates depending on your income, the type of investment you’ve sold, and how long you held it. Some key learnings:

1) If you are currently in the 10-15% tax bracket, you can take advantage of the LOW LOW capital gains tax rates of 0-5% that apply to your gains from the sale of investment securities after one year. Higher wage earners do not qualify for this nifty perk.

2) The famous 15% rate applies to folks in the 25% or higher brackets who sell investment securities after one year. An exception to this rule is if you’re invested in Real Estate Investment Trusts (REITs), which is counted as a real estate investment and is taxed at a rate of 25%.

But this information all pertains to investments that you’ve held for more than a year.

If you own mutual funds in a taxable account, which would be pretty much any account besides an IRA or 401K, you will pay capital gains tax periodically throughout the year while you own the fund, even if the fund has a losing year. The reason for this is that with a mutual fund, individual stocks that make up that fund are bought and sold every once in awhile. If you have an actively managed fund, this could happen quite frequently (this is one advantage to index funds-they tend to hold on to the same stocks for a long time, so there are less capital gains).

Each time the fund manager sells one of those stocks in the fund for greater than the price for which it was originally purchased, that is a taxable gain for all of the folks who own shares of that mutual fund. It doesn’t matter whether you just bought the fund yesterday and the stock that is sold was originally bought two months ago. If you own the fund, you pay taxes on all gains, otherwise known as “distributions.” You also pay capital gains taxes on the dividends that individual stocks in your fund distribute periodically, even if those dividends are automatically reinvested into your account.

One exception to the distributions scenario is with Exchange Traded Funds (ETFs). If you read my post on these interesting little hybrid investments, you know that an ETF is like an index fund because it invests in the stocks that make up a certain defined index, but its shares can be traded actively during the day like an actively managed fund. However, you don’t get taxed on your capital gains until you sell the ETF, so your gains grow tax deferred for a longer period of time. Read more about capital gains taxes on mutual fund profits at About.com.

So what’s the bottom line? If you own a mutual fund that isn’t an ETF, you will be taxed periodically throughout the year on your distributions at your ordinary marginal tax rate (a.k.a. your tax bracket, a.k.a. the short-term capital gains rate), and you will also be taxed when you sell the fund. If you’ve kept the fund for more than one year, your profits will be taxed at the long term rate of 0%, 5%, or 15%, depending on your tax bracket. If you sell in less than one year, you will be taxed at your marginal rate, the same rate that will apply to your periodic distributions.

Is it worth it? Stay tuned for tomorrow’s post, The Ins-and-Outs of Capital Gains Tax Part II, for my two cents on that question.