Wednesday, January 27, 2010

Understanding Capital Gains Tax

Understanding Capital Gains Tax

Most folks have little or no understanding of our tax system. As I have mentioned before, no one really makes it easy to understand, and many folks would prefer you didn't understand it. They show you huge volumes of the tax code and TELL you it is "too complicated" to understand.

But it really isn't all that difficult. Most of those huge volumes don't even apply to you. Basic tax code is not all that hard to understand - at least at the level where it applies to your finances.

Ordinary income is taxed on a progressive basis. So the more you make, the more you pay in taxes - on the increased amount. The table below illustrates the actual rates for 2010:

Year 2010 income brackets and tax rates
Marginal Tax RateSingleMarried Filing Jointly or Qualified Widow(er)Married Filing SeparatelyHead of Household
10%$0 – $8,375$0 – $16,750$0 – $8,375$0 – $11,000
15%$8,376 – $34,000$16,751 – $68,000$8,376 – $34,000$11,951 – $45,550
25%$34,001 – $82,400$68,001 – $137,300$34,001 – $68,650$45,551 – $117,650
28%$82,401 – $171,850$137,301 – $209,250$68,651 – $104,625$117,651 – $190,550
33%$171,851 – $373,650$209,251 – $373,650$104,626 – $186,825$190,551 - $373,650

But the main thing to understand is that if you are in the highest bracket, the last dollars you make are taxed at about 35%.

Ordinary income includes wage income and ordinary dividend and interest income. But wage income is also subject to another tax - or taxes - for social security and medicare. This amounts to about another 8% in taxes, and your employer matches this. If you are self-employed, you end up paying about 16% which represents what you would have paid in social security and medicare taxes, plus the matching amounts from your employer. So a dollar made at a wage job is worth more than a dollar made when self-employed.

Capital Gains are considered to be money made on the appreciation of an asset, such as stocks, houses, and the like. If you buy $100 of stock and a year later you sell it for $200, you have a Capital Gain of $100. At the time of this writing, Capital Gains are taxed at a flat 15% rate. (UPDATE 2022: See chart above - Capital Gains have been adjusted during the Trump administration).

What constitutes a Capital Gain is often an artificial construct and one reason many folks argue the tax should be eliminated. To begin with, we tax only "realization events" - usually where you buy or sell an investment. So if your stock goes up $100, that is not a "Realized Capital Gain" until you actually sell it at that price.

If you buy a stock for $200 and then sell it for $100, you have a loss of $100, which can be used to offset other gains or income and thus reduce your taxes.

If you buy a rare Ferrari as an investment and sell it for double the money, that is a Capital Gain and you have to pay taxes. However, if you buy a Ford Taurus for your personal use for $25,000 and sell it five years later for $12,500, that is not considered a "loss" you can write off. Go Figure.

Similarly, if you buy a stock 20 years ago for $100 and today sell it for $200, you owe taxes on the $100 "Gain". However, over 20 years, that is not much of a rate of return, considering inflation, and arguably you actually lost money.

Some have proposed amending Capital Gains taxes to account for inflation, but others have argued that it would be a nightmare of accounting. Yet others say "get rid of it entirely".

One argument against the "get rid of it entirely" crowd is that it is possible to take dividends in a company and pay them out as stock (as in a split) and thus avoid taxation as dividend income (and people do this already). If there were no Capital Gains tax, there would be no taxation on most income from stocks (and some argue this is fair as well!).

As noted above, Capital Gains are calculated based on what you PAID for the investment, subtracted from what you SOLD it for. We call the amount you sell it for "Amount Realized" or AR, and the Amount you Paid for it your "Basis" or "Adjusted Basis" or AB.  So the formula for Capital Gain is very simple:


But why do we call it "Adjusted Basis"? Well, sometimes, other parts of the tax code allow you to change the Basis value along the way - usually to lower it. This is called Depreciation. And that is the subject of our next post!