Anytime an investment (like stocks, bonds, commodities, precious metals, futures or options) increases in value, the earnings are called capital gains. Below is a simple illustration of the capital gains concept:
- Susan purchased 100 shares of Company ABC stock at $10 per share (a total investment of $1,000).
- The Company ABC share price rose to $15 per share during the three years that Susan held the investment.
- Susan still owns 100 shares of Company ABC stock, but her shares are now worth $1,500.
- Susan had a capital gain of $500 because her investment’s value rose from $1,000 to $1,500.
- Most people think about capital gains in terms of the sale of an investment. If Susan sells her 100-share investment in Company ABC when the shares are worth $15, the capital gain upon sale would be $500.
Capital Gains Taxes
People often use the term capital gains interchangeably with the term capital gains taxes. The IRS treats capital gains differently than regular income. Investors who sell an investment with a capital gain must pay capital gains taxes on the earnings but not on the principle. In the example above, Susan would need to pay capital gains taxes on the $500 in earnings upon sale of the investment. It is important to note that people are not double-taxed – capital gains are not taxed again when the investor pays income taxes.
People who owned an investment less than a year owe short-term capital gains taxes. Though the tax is separate from income taxes, the investor is taxed at ordinary income tax rates – which can be as high as 35%. Long-term investments, held more than a year, are generally taxed at a rate of 15%. During 2012, investors who are in the two lowest tax brackets (10% and 15%) are at the same short-term capital gains tax rate as their ordinary income tax rate and do not pay long-term capital gains tax. Beginning in 2013, unless the law changes, investors in the lowest tax bracket will be liable for a 15% short-term capital gains tax rate and a 10% long-term capital gains tax rate, and the qualified five-year capital gains rate will be reinstated.
Capital Gains in Mutual Funds
Mutual funds buy and sell investments throughout the year. When a fund sells a security for more than the purchase price, the appreciation is considered a capital gain. A mutual fund is required to distribute capital gains annually to shareholders in order to avoid capital gains taxation at the fund level. When a fund makes a capital gains distribution, the net asset value (NAV) decreases by an equal amount. For example, if a fund makes a $0.75 capital gain distribution when the NAV is $38.00 then the NAV will drop to $37.25.
If you would like to know whether any of the funds you own will pay out capital gains distributions, you can contact the sponsoring mutual fund company. Most fund companies declare year-end distributions in late November or early December. Mutual fund shareholders have the option to have capital gains distributions reinvested or paid in cash. Capital gains taxes are due with ordinary income taxes regardless of whether capital gains distributions were reinvested or paid out.
Capital Gains in Company-Sponsored Retirement Plans
In company-sponsored retirement plans, capital gains distributions are automatically reinvested into the respective mutual fund. Because company-sponsored retirement plan investments are allowed to grow tax-deferred, capital gains taxes are not paid on these investments. Despite the rules that govern their underlying investments, employer-sponsored retirement plans (and similar individual retirement plans, like IRAs) are never subject to capital gains taxes. Retirement distribution withdrawals from these plans are treated as regular income and are subject to ordinary income tax.