When an asset is sold for a higher amount than it was purchased for, the difference is known as a capital gain.
On the other hand, if an asset is sold for less than it was purchased for, the loss is known as a capital loss.
Understanding how capital gains and losses work and how they are taxed is an important aspect of investing and retirement planning.
Realization of Capital Gains and Losses
Under most circumstances, a capital gain or loss must be “realized” in order to trigger a taxable event. A gain or loss is realized when the asset is sold for either more or less than the original purchase price.
Let’s look at a couple of examples.
Suppose you bought 100 shares of XYZ Company at $10 apiece. Two years later, the share price has risen to $15 per share. If you sell your shares, you will realize a $500 capital gain ($1,500 value of shares minus $1,000 purchase price).
Conversely, let’s say that the share price declined to $5 during that two-year period. Upon selling your shares, the difference between the market value of the shares and the original purchase price would represent a $500 capital loss.
Tax Treatment of Capital Gains
Capital gains are taxed in the year they are realized. The U.S. federal tax treatment of a capital gain depends on whether the gain was short-term or long-term.
A short-term gain occurs if the investment is held for one year or less. This means that the gain will be taxed at the investor’s top marginal income tax rate.
If the investment was held for more than one year, the gain is taxed at the investor’s long-term capital gains rate. That’s usually lower than the income tax rate. As of 2018, the long-term capital gains rates are 0%, 15% and 20%. An individual’s level of total taxable income determines their long-term capital gains rate.
Tax Treatment of Capital Loss
Capital losses are categorized as short-term or long-term in the same manner as capital gains. Capital losses are netted against capital gains of the same term in the year they are realized. This results in a reduction in taxable income.
There is no limit to the amount of a capital loss that can be netted against a capital gain. However, $3,000 is the maximum amount that a capital loss can offset other types of income (such as earned income) in a given year.
Capital Gain/Loss in Retirement Planning
Many people use individual retirement accounts (IRAs) when saving and planning for retirement. The sale of an asset in an IRA is not considered a capital gain or loss, as far as taxes are concerned. This is because IRAs are tax-deferred, meaning that taxes are not due on gains until they are withdrawn.
IRA contributions and earnings are combined and are fully taxable once withdrawn. If you withdraw from your IRA after age 59½, the amount is taxed at your ordinary income rate. Withdrawals prior to 59½ will be subject to income tax, plus a 10% IRS penalty.