Tax Implications of Capital Gains Reinvestment: What You Need to Know
Investing in assets is no easy task. All trade markets have ups and downs, and many who’ve tried their hand end up getting scorned. However, others have used these markets as stepping stones to a brighter future. Some have even become millionaires. Once you make it big in the trading world, you will undoubtedly come across the concept of capital gains tax. Some people do not understand what “capital gains” means. Others do and learn to work within the parameters of a capital gains system. However, a few choice traders have discovered ways to minimize their capital gains tax through reinvestment. So, let’s take a look at the implications of capital gains reinvesting.
What is Capital Gain?
Capital gain refers to a capital asset’s growing value when sold. Let’s take an example. You’ve bought some stocks. They’ve accumulated in value, and you’ve sold them. Your capital gain is the difference between their original value and the value you sold them for. In other words, the capital gain is the profit you make from selling stocks with increased value.
What is a Capital Asset?
Capital assets are all the assets that a business owner may hold, regardless of whether they are connected to their business. The point of a capital asset is to generate value over time, usually. So, going by this rather broad definition, a capital asset can be anything, from material possessions like furniture, vehicles, jewelry, and even your home to immaterial possessions like stocks, shares, and securities and even abstract possessions like goodwill.
What is a Capital Gains Tax?
Capital gains tax, or CGT, is the taxation of profits acquired by selling capital assets. CGT commonly applies to selling stocks, bonds, gold, silver, real estate, property, etc. Capital gains taxes don’t exist in every country. For example, the New Zealand government does not impose a CGT at all. However, for US residents, the CGT on assets held for less than a year corresponds to ordinary income taxes. So it would be anywhere between 12% and 37%, depending on the income. Though, it is worth noting, capital gains tax rates can change each year. So, you ought to bear that in mind when dealing with CGT.
What is a Capital Loss?
The inverse of a capital gain would be a capital loss. So, for example, if you purchased a stock for $10, and sold it for $5, you would have lost five bucks. That lost revenue is the capital loss we are talking about. In the United States, there are laws which suggest that you can use your capital loss to offset our capital gain. We will touch further on this concept, and how it impacts the tax implication of capital gains a bit further in this article.
Reinvesting Capital Gains
The question that most investors face is this: “Should I collect my capital gains as cash, or should I reinvest them?” The dilemma has plagued investors for years, and many are anxious about making the right decision. So, just what can happen if you reinvest your capital gains? Let’s explore the possibilities.
Benefits of Reinvesting Capital Gains
The most significant advantage of reinvesting capital gains is that you are playing with more money than you originally started. Meaning, if you make the right calls, you can make a lot more money. And on top of that, you will also get the benefit of delaying CGT payments to the Internal Revenue Service. We will discuss this in further detail a bit later when we go over the tax implications of capital gains reinvestment.
In terms of the act itself, you should have no trouble with it. After all, it is as simple as contacting your investment manager and instructing them to reinvest your gains into rising markets. If you choose to do this, you will not be charged a commission, so it is a win-win scenario in many ways. Although, there are some downsides to reinvesting your capital gains.
The Downsides of Reinvesting Capital Gains
The biggest, and most obvious downside is that you get no spending money. Basically, all of the cash that you’ve earned from trading goes back into trading. So, while in the long-term you may end up richer, in the short term, you break even. If you are doing well, this might not be much of a problem. However, if you need the money to meet certain obligations, trouble arises.
And of course, there is the other major risk. Namely, every investment comes with the risk of failure. So, once your investment pays off, you will have a decision to make. “Do I want short-term gains?” If yes, then collect your money, and be on your way. Or “Do I want long-term gains?” If so, reinvesting is probably the better choice.
Capital Gains Tax
We discussed what capital gains tax is, but what we didn’t talk about is the impact reinvesting has on the CGT. To better understand this, we need to discuss the difference between short-term capital gains tax and long-term capital gains tax.
What is long-term capital gains tax?
As the name would suggest, a long-term capital gains tax is a CGT on profits made from the sale of an asset that an investor has held on to for more than a year. It is important to note that a CGT rate varies depending on the investor’s income. For those with a higher income and a better filing status, the CGT can reach 20%. An investor might not be taxed for long-term capital gain if their regular, taxable income is middling or non-existent. The average for a long-term CGT is 15%, so bear that in mind when holding on to an asset.
What is short-term capital gains tax?
Inversely, a short-term CGT is a tax on profits made from an asset sale that an investor has held onto for a year or less. We already touched on this before, but a short-term CGT is usually equivalent to the typical income tax rates we all deal with. The short-term capital gains tax can be 10%, 12%, 22%, 24%, 32%, 35%, or 37%. In other words, the short-term CGT is actually higher than the long-term, which is another factor to consider when holding on to assets.
The Tax Implications of Reinvesting
Finally, we reach the point where we talk about the taxation implications of reinvesting capital gains. We touched on this briefly before and promised a longer explanation. So here it is. As you are all aware, the Internal Revenue Service (IRS) is in charge of collecting taxes. Naturally, this applies to CGT as well. So, when you make your capital gain, it is the IRS’ job to calculate the capital gains tax you must pay. However, if you decide to re-invest your capital gains, you delay this process because you’ve basically made nothing.
It is essential to understand that you will eventually have to pay the capital gains tax. It is unavoidable. However, delaying the process gives you more time to plan your taxation obligations and payments. More importantly, we already discussed the short-term vs. long-term CGT. And as we discovered, the highest percentage for a long-term capital gains tax is lower than the short-term. So, ultimately, it may benefit you to hold on to the money longer and have the IRS mark your capital gains as long-term.
Gains and Losses
Another way in which many investors offset their CGT is by coupling their capital gains with their capital losses. In fact, most experienced investors recommend taking this route rather than the reinvestment route. The idea is simple. The IRS lets investors offset their yearly gains with their annual losses. So, by coupling a successful stock with a dud, you can reduce your tax rates. The best part is that failures don’t impact your taxes unless you have gains to offset. So, in other words, you have nothing to lose and everything to gain.
Can You Avoid Capital Gains Tax?
There is no way out of paying taxes. Whether you offset the gains with losses or you delay the inevitable, you will eventually have to pay the CGT, whether you want to or not. Your best defense against the CGT is to go the long-term investment route. By holding on to your stakes, you don’t have to recognize capital gains, which gives you ample time. For this reason, some investors hold on to their stocks for years or even decades.
The question of whether you should reinvest capital gains and dividends or not plagues many investors. There is no simple answer we can give, hence this article. By reinvesting your capital gains, you minimize the capital gains tax that all investors have to pay. On top of that, you delay the inevitable, and in doing so, you give yourself more time to come up with a better tax plan and payment strategy. However, there is no way to avoid CGT; sometimes, you need a short-term investment. So, ultimately we can’t answer the question for you. But, hopefully, this article has provided you with the tools you need to come up with an answer yourself.