Investing in assets such as stocks that have the potential to increase in value over time is a common wealth-building strategy that raises several tax considerations. When you sell a stock for an amount that is greater than the original price you paid, you make a return called a capital gain. The Internal Revenue Service imposes taxes on capital gains based on how long you hold investments before selling them.
When you sell a stock within a year after buying it, any profit you make from the sale is a short-term capital gain. These are subject to a tax rate equal to your normal marginal income tax rate based on your total annual income. For high-income people, the tax rate on short-term capital gains can be as high as 35 percent, while average workers are likely to pay 15, 25 or 28 percent.
Stocks you hold longer than a year are subject to a long-term capital gains tax rate when you sell them. This tax rate is capped at 15 percent, so even people in the top income tax bracket pay only 15 percent on long-term gains. If your normal income tax rate is 15 percent or 10 percent, you don't owe capital gains taxes on long-term stock gains.
It is possible to avoid capital gains taxes entirely on investments held within certain tax-advantaged retirement accounts. Retirement accounts including 401(k) plans, traditional IRAs and Roth IRAs offer tax-deferred investment gains, which means you don't pay capital gains tax on investments in your accounts. With 401(k) plans and traditional IRAs, you pay normal income taxes on withdrawals. With Roth IRAs, you generally do not owe taxes on withdrawals.
When you sell a stock at a price that is lower than the amount you paid for it, you incur a capital loss instead of a gain. If your capital losses for a year exceed your gains, you have net capital loss. This means you don't have to pay any capital gains tax and you can actually take a tax deduction on the loss. According to the IRS, the maximum annual capital loss deduction is $3,000, as of 2012. You can carry losses that exceed the limit forward to later tax years.
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.