Short-term vs. Long-term Capital Gains

For any investor, one of the most important distinctions is the one that lies between short-term capital gains and long-term capital gains. The taxes you pay on your investment earnings depend on the holding period of your investment. You will be able to better plan your investment buying and schedule, and use it to better reach your financial goals, when you plan according to your investment holding period.

Short-term or Long-term?
First of all, you need to understand the difference between short-term and long-term investments. It’s a fairly basic rule of thumb:

• Short-term investments are those held for one year or less.
  
• Long-term investments are those held for more than one year.

If you bought a stock on April 1, 2010, you need to keep it until April 2, 2011 if you want it considered long-term. This is because an investment held for exactly one year is considered a short-term investment.

There is often confusion regarding investors who make use of dollar cost averaging. After all, with this technique, you don’t just buy a few shares and let them sit. You are constantly investing more. If you decide to sell some of your shares after dollar cost averaging, you will need to figure out whether the shares you sold are long-term or short-term.

In these cases, it is generally assumed that your sale will follow the first in, first out rule. This means that the shares you sell will automatically be the first ones you bought. The IRS assumes this rule (as do brokers and fund managers), unless you specify otherwise. If the first you shares you bought are more than a year old, chances are that they will be long-term investments. (This may not be the case if you sell more shares than you originally bought more than a year ago.)

There is also a method of cost averaging, which can be used if you don’t use the first in, first out rule. Cost basis is figured by adding up your shares and dividing by prices paid for them. You might want to contact your fund manager, or a tax professional, to find out more about this. Know, though, that if you decide to go with cost averaging rather than first in, first out on a fund, you will have to follow that method of determining cost basis on each sale.

Paying Capital Gains Taxes
When it comes to paying capital gains taxes, how much you owe depends on whether the investment is a short-term gain or a long-term gain. Short-term gains are taxed at your regular income tax rate. This means that if you are in the 25% tax bracket, your gains will be taxed at the marginal rate.

Long-term gains, on the other hand, are taxed at a different rate. As of this writing, if you are in the 10% and 15% brackets, there aren’t taxes on long-term capital gains. The story changes, though, when you reach the 25% tax bracket. At that point, capital gains are taxed at 15%. If you are in a higher tax bracket, that can mean real tax savings. These levels are set to last through 2012. After that, capital gains on long-term investments will be taxed – but likely still at a lower rate than your marginal tax rate.

Understanding these differences might prompt you change your mind about when you sell an investment, since you might save money if you wait a little longer.

About the Guest Author
Miranda Marquit writes about personal finance for a variety of web sites. She has her own blog at AllBusiness.com, and provides content for InsuranceQuotes.org, a site providing online insurance quotes.
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