I've been seeing a lot on capital gains here in the news lately and wanted to educate myself. I knew what they were in theory, but there seems to be a lot of arguments going around about them and their related taxes. After doing my research I thought it might be beneficial to you as well. So here goes...
Capital gains defined on Wikipedia:
The profit realized on the sale of a non-inventory asset that was purchased at a lower price. The most common capital gains are realized from the sale of stocks, bonds, precious metals and property.
Real world example: On January 1, 2011 you buy Apple stock for $100. On December 31, 2011 you sell your Apple stock for $200. Profit of $100 ($200 sale price less $100 cost).
Currently, USA has a 15% tax on capital gains. Therefore, you would pay tax on your $100 profit. You would pay $15 in tax and be able to bring home $75.
Generally, the 15% tax rate is lower than your ordinary income taxable rate. Robert and I pay around 25% in income tax. Why is this rate lower?
Well, to continue the example above: I bought a $100 of Apple stock. For me to buy that stock, I would have to pay 25% already on my income. So, to have a $100 to buy Apple stock, I would have needed $125 in income. So, I've already been taxed at my ordinary income rate on this money that I'm putting into the stock market. Then, I get taxed again when I sell my $100 stock for a profit. You are also only allowed a $3,000 deduction for your losses a year, too so while you can be taxed on your winnings... you don't get much of a benefit for your losses.
Generally speaking, the reason the 15% rate was assigned to capital gains was because its under the belief that people would invest less if those capital gains were taxed at their ordinary income rate. The lower rate spurs more investing and the 15% rate would generate more income to the government than say a 30% tax rate would because there would be less money out in the market earning gains.
Final example:
Annual Income: $1,000,000
Tax Rate: 30%
Taxes Paid: $300,000
Take home pay: $700,000
Assuming current 15% tax:
Invest $500,000 in the stock market. Earn $30,000 on stocks (6% return). Pay 15% on that profit: $4,500. Total take home profit: $25,500
Assuming 30% tax:
Invest $500,000 in the stock market. Earn $30,000 on stocks (6% return). Pay 30% on that profit: $9,000. Total take home profit $21,000.
With the higher capital gains tax rate, its the belief that the investor would invest less to pay less in taxes since the investor is being taxed on that money once already. Instead of paying more taxes here, the investor would likely move his money to other countries where capital gains taxes are lower or non-existent (USA has one of the highest capital gains tax rates in the World).
Anyways, that's pretty much the jist of it. There's really a lot more to it in that these calculations don't take in the rate of inflation. If you have a 2% rate of inflation, that 6% actual return you earned above is really more like a 4% realized return, but you're going to pay tax on the full 6% even though inflation just ate up 2% of your return. Sad day.
Here's a great article explaining capital gains and taxes to further your knowledge. Hope this has helped!
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