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Friday, November 20, 1998
Tax Q&A
by Roy Lewis
Capital Gains Tax Changes
It is painfully obvious that there are still a number of people out there under the mistaken impression that an 18-month capital gain holding period is significant. It's just not true.
So in order to put this matter to rest, I thought I'd crack open The Motley Fool Investment Tax Guide to see what it had to say on this issue. And while this is only a very abbreviated reprint of the capital gains section, you can clearly see what the new laws are all about. So here you go, directly from the Tax Guide...
In 1997, as part of the 1997 Taxpayer Relief Act, the IRS unveiled a shiny new capital gains tax schedule, with some rates considerably lower than before. (These rules were tweaked further in 1998.) What rate applies to you specifically? Well, it all depends on:
- the type of asset you sold
- your cost basis
- the length of time you held the asset before selling it
- your income level
Qualifying for the lowest new rates are stocks, bonds, mutual funds and many other capital assets. Taxed at a slightly higher rate are business or rental real estate, collectibles, depreciation, and some other things...
There are two holding periods for capital assets sold on or after January 1, 1998. Assets held for a year or less are considered short term. Those held for more than one year are considered long term.
Here's the bottom line:
If you're in the 15% tax bracket:
Assets held for a year or less: Taxed at ordinary income tax rate
Assets held for more than a year: 10% tax
If your tax bracket is greater than 15%:
Assets held for a year or less: Taxed at ordinary income tax rate
Assets held for more than a year: 20% tax
Note that when you place an order to buy or sell a security with your broker, there will be a "trade date" and a "settlement date" recorded for the order. Which one counts for tax purposes? The trade date, which is the date that the order was executed. (The settlement date is the date when the cash or securities from the transaction are plunked into your account.)
That's the lowdown on the new capital gains tax rates. What does it all mean for you as a Foolish investor? Well, a quick glance at the numbers above reveals the most important implication: The longer you hold your stocks, the less tax you're probably going to pay.
One bone of contention between Fools and the Wise is the value of holding stocks for the long term. A Foolish investor usually tries to find great companies in which to invest, aiming to hold the stock for years (or decades) as long as the reasons for buying the stock remain unchanged. The Wise, though, will frequently assert that it can be more profitable to jump in and out of the right stocks at the right time, holding them until you reap the expected gain or until something better comes along.
Look at your own situation and tax bracket. For example, if you hold onto a security for longer than a year, you're likely to be paying 20% of your gain in taxes. If your holding period is a year or less, the gain could be taxed as much as 39%. With a mere $1000 gain, that's a difference of $190, or 19%. Are your short-term trading earnings going to be substantial enough to compensate for the fact that you'll be paying nearly twice as much in taxes? Not likely.
For more information, review IRS Publications 544 (Sales and Other Dispositions of Assets) and 550 (Investment Income and Expenses), available from the IRS website: www.irs.ustreas.gov
Please note that Roy cannot answer individual questions via e-mail. If
you have tax questions, please ask them on the taxes message board. Thanks!
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