Calculating capital gains tax
Narrator says a long-term gain does not affect gross income; in fact long-term gains are included in gross/taxable income but taxed at preferential rates. He also says 'held 12 months or longer' where the IRS rule is more than one year; questions avoid testing either claim.
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The video compares a $1,000 profit on stock held for 11 months with the same profit held for 13 months. Short-term profit is taxed as ordinary income at the person's 12% marginal rate ($120 tax), while long-term profit is taxed at capital gains rates, which here are 0% and often 15%. Holding assets over a year usually lowers the tax owed.
You'll be able to
- explain the difference between ordinary income tax and capital gains tax on a profit.
- calculate the tax on a short-term gain using a marginal tax rate.
- explain why holding an asset for more than a year can reduce taxes.
Key words
- Capital gain
- Profit from selling an asset, like stock, for more than you paid.
- Ordinary income
- Income such as wages, taxed at normal bracket rates; short-term gains are treated this way.
- Capital gains tax
- A usually lower tax rate on profit from assets held for more than a year.
- Marginal tax rate
- The rate on your next dollar of income.
Transcript
- [Narrator] If you plan on making money by buying and selling assets, it's really important to know the difference between capital gains tax and ordinary income tax. So let's say you were to go out there and you were to buy a certain amount. Let's say you were to buy stock, and you were to pay $1,000 for it, and then 11 months later, 11 months later, you were to sell it.
So you buy, you buy it for $1,000, and 11 months later you sell it for, you sell it for $2,000. So that's good. You made money on that stock. And what was your gain, or what was your profit here? Well, you made $1,000. Now because you kept it for less than a year, this is not going to be considered a capital gains.
It's actually going to be considered ordinary income. Ordinary income because you held it for less than a year. And so how is it going to get accounted for? Well, this profit is just going to go to your gross income. So instead of $60,000, which is an example that we saw in other videos, now you would've made $61,000.
And after the standard deduction, your taxable income is $46,000. And then you would go into your tax brackets. Before you were paying, you had to take home a 54,839. That incremental $1,000 of income, you're still going to be in this 12% tax bracket. So on the margin, you are going to be taxed at 12% of that income.
So 12% of that extra $1,000, you're going to only get $880 of that. So you're going to get an extra $880 is going to be your to take home. So as you see in this scenario, when you kept it for only 11 months, you had to pay 12% on that profit. You had to pay $120.
Now, in another very similar scenario, you bought it for $1,000. But instead of holding it for 11 months, let's say you hold it for 13 months. So clearly more than a year, you still sell it for $2,000. Your profit is still $1,000. So it's a very similar scenario, but in this scenario, it's not considered ordinary income anymore.
So it's not going to affect your gross income like it did before, so none of that is going to happen. And instead this is going to trigger capital gains tax. And in general, capital gains tax is going to be lower than ordinary income tax. I looked it up on the IRS website, and if you're an individual filer and you make less, and if your taxable income is less than 47,025.
And so even though our gross income is more than that, our taxable income here is 45,000. So we go into that category. We actually have 0% capital gains. So when I held it for 11 months, or even 11.9 months, you know? 11 months and 29 days, I had to pay 12% on that because that was my marginal tax rate 'cause it was ordinary income.
But if I held it just a little bit longer, if I hold it just to 12 months or longer, now, based on where my income is, my taxable income, I had to pay 0% on it, so I'm getting an extra $120. I'm getting to keep this whole thing. And even if I had a higher taxable income than this, the capital gains rate tends to be about 15%.
And 15% is still a good deal because if you look at these higher tax brackets, the marginal tax rates go up 22% and then even higher and higher from there, so 15% capital gains is going to be really good for most people. In fact, in almost all circumstances, you're better off holding, if you care about optimizing your taxes, you would wanna hold it for at least a year to pay capital gains and not ordinary income.
And this doesn't just apply to buying and selling stocks. It could apply to buying and selling something like a house, something, any asset that you're making money off of the sale of it. It could be jewelry, it could be Bitcoin, but when you hold it longer, over a year, you pay less taxes on it.
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