Making More Money from Capital Gain Taxes

As we may know, keeping a diversified portfolio can be beneficial to the overall health of our financial stability and growth. Taking a closer look at each investment, they fall into two categories of taxes: capital gains tax and ordinary tax. Many people have both types of taxes within their portfolio but are not sure which tax applies to the investments.

Which Tax is Which: Capital Gains and Ordinary

Capital gains tax is applied on profits realized from the sale of capital assets such as a home, certain investments and dividends and business interests. The best way to determine how an investment is taxes is to simply ask, "What occurred with the investment this year?" If the investment generated income such as interest, the income will probably be considered ordinary. But if you sold the investment for a profit then it will be determined a capital gain.

Capital gain is generated when the sale price for a capital asset exceeds your adjusted tax basis in that asset. Generally, your adjusted tax basis in an asset equals the price you paid for the asset with some adjustments. However, different basis rules may apply to assets acquired through gift or inheritance.

Retaining Income Through Capital Gain

Capital gain income is generally preferable to ordinary income. Currently, the highest marginal income tax rate is 35 percent, while long-term capital gains tax rates vary from 5 percent to 28 percent, depending on the asset and your marginal tax rate.

Here's how capital gain is taxed. Taxation of capital gains depends on how long you owned or held your investments before selling. Assets that are held for less than one year generate short-term gains and are taxed at the ordinary income tax rates. If you hold the asset for more than one year, it is considered a long-term capital gain. The applicable long-term capital gains tax rate is determined by the type of asset and your marginal tax bracket. For taxpayers in tax brackets higher than 15 percent, the rate is generally 15 percent. For taxpayers in the 15 percent and 10 percent brackets, the rate is 5 percent. This applies to sales and exchanges made after May 5, 2003 and before January 1, 2009.

Too Much Income

If selling an asset that you've held on to for more than a year puts you into the higher tax bracket, you may not be taxed at 5 percent. You can use a preferred capital gains tax rate of 5 percent on a portion of the capital gain only. The remainder of your capital gain will be taxed at the higher 15 percent rate.

Net it Out with the Netting Rules

In order to properly compute your capital gains tax, you should be aware of the manner in which capital gains and losses may offset one another. These rules are known as the "netting rules." Generally speaking, the tax code prescribes that short-term capital gains and losses must be netted against each other first. Next, long-term capital gains and losses are netted against one another according to a set of ordering rules. Finally, net short-term gains or losses must be netted against net long-term gains or losses in a prescribed manner.

Capital losses are netted against capital gains. Up to $3,000 of excess capital losses is deductible against ordinary income each year. Unused net capital losses are carried forward indefinitely and may offset capital gains, plus up to $3,000 of ordinary income during each subsequent year.

Knowing is the Key

The key to making the most of your money is deciding when to keep or sell your investments. But when you do, you now know how it can be taxed. Be sure to consult your financial planner or accountant to verify the tax rate so your decision is the best one.