Capital refers to financial assets or the financial value of such assets. When discussing investing – including investing for retirement planning – it’s money someone invests and the value of those investments as their market value rises or falls.
Capital appreciation is the increase in an asset’s value due to an increase in its market price. In the context of investments, it can refer to an increase in the price of a stock or mutual fund share or an increase in a bond’s market value.
It’s a very common investment objective. Investors will look for assets that are expected to increase in market value over the period the investments are held. Dividend and interest income are not of primary importance to these “growth” investors.
Capital Gains & Losses
A capital gain is realized when an asset is sold for more money than it was purchased for. These gains are taxable in the year they are realized.
A short-term gain occurs when an asset is held for a period of one year or less. Short-term gains are taxed at the investor’s top marginal income tax rate.
A long-term gain, on the other hand, occurs when an asset is held for a period of more than one year. The tax rate on long-term capital gains can be 0%, 15% or 20%, depending on the investor’s total income. It is usually lower than their top marginal income tax rate, though.
It’s unfortunate, but not all investments work out. When an asset is sold for less than what was paid for it, the silver lining is that the capital loss can offset taxable income. Capital losses, like gains, are classified as either long-term or short-term. There is no limit to how much of a loss can be used to offset gains of the same term. These losses can also offset other types of income – such as earned income – but the amount is limited to $3,000 per year.
Value in Retirement Accounts
When using an individual retirement account (IRA) for retirement planning, your contributions to that account may be considered capital. This is treated a bit differently for tax purposes, though.
IRAs are funded using money that has not yet been taxed. IRA contributions and the gains that appreciate them are combined and taxed at your ordinary income tax rate when you withdraw from your IRA. Premature withdrawals (taken before age 59½) are subject to a 10% IRS penalty in addition to income tax.
Capital gains are also tax-deferred in an IRA, so selling an asset in your IRA at a profit will not result in a tax bill for that year. However, if you sell an IRA asset at a loss, you cannot deduct the loss from your income.