Capital Gains Tax

Whenever an election comes around, the discussion over taxes is revisited. What does this have to do with investing? More people than ever are owning stocks. The last number we heard was over 110 million North Americans. This group is raising an issue regarding a tax that affects investment profits--the capital gains tax.

In the simplest terms, a capital gain is the difference between what you purchase and sell an asset for. If you own stocks, mutual funds, bonds, or any other investment asset, the government taxes 20 percent of your gain from investments held for more than one year.

Let's take a quick look at how the capital gains tax works. (Keep in mind specifics here refer to the U.S., although the principles apply to nearly all countries). Bought 100 shares of XYZ @ $20 $2,000
Sold 100 shares of XYZ @ $50 $5,000
Capital Gain $3,000
Capital Gain taxed @ 20% $600
Profit After Tax $2,400

Uncle Sam is sinking his teeth into $600 of your profits, but that, however, is not the worst part. Had you held the stock for less than one year, your profit would have been a short term capital gain, which is taxed at your income tax rate, as high as thirty-nine percent. Also note, you only pay capital gains tax once you sell your investment and realize the returns.

Most people think the $600 tax loss is the last of their worries, but this is where the real problem with capital gains begins, unless you are a true buy and hold investor. It starts with the rules of compounding, an asset's earnings that are reinvested to generate even more earnings. If you buy and sell stocks every few months, you are undermining the possibility of compounding because you keep on getting dinged with taxes.

The reason for this is the difference between an unrealized gain and a realized gain. A stock may go up and down in value every day, but the gains go unrealized until you sell. When you do sell, the gains are then said to be realized, which triggers tax.