Home

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

Uncle Sam Wants a Piece of Your Capital Gains

If you haven’t read my last post introducing capital gains, you might want to do that first. With all these taxes, is it even worth it to invest in taxable accounts in the first place? Especially when you take inflation into account? Well, it certainly shows you why tax-advantaged accounts like 401Ks and IRAs are a wonderful thing. With a Traditional IRA, you can get a tax deduction in the year you invest your principal (if your income falls below a certain limit) and then your money grows tax free until you withdraw it when you retire. With a Roth IRA, you don’t get a tax break now but you will NEVER EVER have to pay taxes on that money once you put it in, and even when you take it out once you’ve retired. Very sweet deal.

BUT with tax advantaged accounts, there are rules about when you can take the money out. Maybe you don’t want to wait until you’re an old geezerette before you put that money to good use. Maybe you have a short-term or intermediate goal, like buying a home or taking a trip around the world. In that case, don’t use your retirement funds for that stuff. Use a taxable account.

Don’t let capital gains tax scare you. If you’re already maxing out your tax advantaged accounts (good girl!) and you want to sock more away to meet your goals, think about the capital gains tax in comparison to regular income. Your regular income is taxed, but that doesn’t keep you from working to earn a living!

If you hold onto the investments for more than a year, the long-term capital gains tax rate is pretty low. What about that pesky periodic distribution tax, which is the same as your marginal tax rate? True, it’s a bummer. But if you think of these tax advantaged investments as an extra income stream, it’s no different than a second job. If you were to go out right now and get another job on the weekend, for example, you would be taxed on that money, probably at the marginal rate. But you’d still end up making more money, and that’s the point, right? Did anyone ever say: “I don’t want to make more money, because then I’ll get taxed more?” Well, perhaps they did, but I wouldn’t turn down a big pay raise even if it bumped me up a tax bracket.

What happens if you lose money with that investment? In that case you have a capital loss, and you can take a tax deduction for that loss up to $3000 for that calendar year. If your loss is more than $3000, you can carry the rest of the loss over in the next tax year and get another tax deduction for the remainder. See my post on what a tax deduction really means to understand how this could impact your bottom line. It’s not like you’re getting all of your money back, dollar for dollar. But it’s just a little something Uncle Sam gives you back to make you feel a little better if you lose, and to reward you for “trying.” Like at the casino, when you lose $5000 and they give you a “comp” dinner.