The stock exchanges in the United States have pretty much recovered their losses from the Great Recession. Those who invested in stocks during the height of the recession may very well be sitting on large unrealized gains. Others might be looking to start investing with short-term gains in mind. Investors and would-be investors need to know the difference between long-term capital gains and short-term capital gains.
One major difference is the tax treatment. For a gain on sale of stock to qualify as long-term for tax purposes, you must have held the stock for longer than a year. Long-term capital gains are normally taxed at a rate of 15%. If you are in the 10% or 15% marginal tax brackets, any long-term capital gains are tax free. If you are in the 39.6% tax bracket, long-term gains are taxed at 20%. Obviously, this gives investors an incentive to hold stocks for long-term gains.
Short-term capital gains are treated as ordinary income and receive no preferential tax treatment. Thus, any short-term gains are included in your adjusted gross income and taxed at the appropriate marginal rate. Say, for example, you bought stock on December 31st of last year for $1,000 and this December 31st it is worth $1,100. If you sold it that day, the $100 gain would be included in ordinary income. If you are in the 25% marginal tax rate, that gain would be taxed at 25%. If you wait a day, you have now held that stock for longer than a year. That $100 gain would now be taxed at 15%, all else being equal.
The main reason for the difference in tax treatment is to encourage people to invest in stocks for long-term gains. Many people have tried speculating on the stock market for short-term gains and lost a lot of money as a result. If making money this way was easy, everybody would be doing it and we would all be millionaires. Picking stocks wisely takes a lot of research that many people simply don’t know how to do or don’t have time to do. The different tax treatments for short-term and long-term gains is to help discourage people from short-term speculation and hopefully keep people from losing a lot of money as a result.
For capital losses, an individual may deduct up to $3,000 per year when arriving at adjusted gross income. If you lose more than that, the remaining loss must be carried forward and deducted in future years. Any short-term losses must be deducted before any long-term losses. With this rule, an investor who loses money every year will never recover his or her losses through deductions. This also encourages investment for long-term gains.
Before investing in individual stocks, any investor should research the company. The financial statements of any publicly traded company are public domain and can be viewed on the Securities and Exchange Commission’s website. Of course, you need to know how to read financial and analyze financial statements before investing. This can take extensive training and is often better left to a professional.
While investing in stocks gives you a good chance to beat inflation, long-term capital gains have a more favorable tax treatment. This and the difficulty in short-term speculation usually makes investing for long-term goals a better option.