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When you hold an investment asset, there are usually two ways to earn a return on your investment. The first is through income payments, such as interest and dividends. The second is through an increase in the value of that asset, which is recognized as a gain — a capital gain — when its sold. With the dramatic rise in the value of financial assets over the past decade, capital gains have come to replace dividends as the primary source of returns on securities. For that reason, lets dive into the more technical aspects of capital gains on stock.

What Are Capital Gains on Stock?

A capital gain is the increase in the value of a capital asset. That asset could be just about anything, but most typically relate to either real estate or financial assets such as stocks, bonds, and mutual funds.

As I mentioned above investments typically produce returns either through fixed-income payments, such as interest and dividends or through capital gains. And just like interest and dividends, capital gains usually trigger a taxable event.

Lets say you purchase 100 shares of stock at $50 per share, for a total investment of $5,000. Six months later, the price of the stock rises to $65 per share. You sell your entire position for $6,500, producing a $1,500 gain on sale.

The $5,000 purchase price of the stock represents your cost basis. The $1,500 gain represents a capital gain. You can use tax software to get your gains and losses. Here are the leading ones:

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Realized and Unrealized gains

One important distinction with capital gains relates to realized and unrealized gains. The example given above represents a realized capital gain. Thats because the stock has been both bought and sold, and the gain has been received.

If the same situation were to occur, but you didnt sell the stock, the gain would be unrealized. This is sometimes referred to as a paper gain because it exists only on paper and hasnt been received in the form of cash.

Only a realized capital gain is taxable because the proceeds have actually been received.

If your stock position grows from $5,000 to $50,000 over five years but you dont sell the stock, the gain is not taxable, because the profit has not actually been received yet.

How the Capital Gains Tax Actually Works

Lets say you bought your $1,000 worth of stock and then sold it eight months later for $3,000, making a profit of $2,000. If youre in the 24% tax bracket, youll pay $480 tax, for a total net gain of $1,520.

What if you decide to wait just a little bit longer? You sell a few months later to claim a long-term profit rather than a short-term profit. Now your stock is worth $3,500, leaving you with a gain of $2,500. Your tax bill at the long-term rate of 15% is $375. Thats right: Youve made a more significant profit, but youre paying less tax because of the favorable rate. Now your total profit is $2,125.

With the favorable long-term capital gains rate, you get to potentially take advantage of further gains and compound those with a lower tax rate. Watch your wealth grow more efficiently by combining the favorable tax rate with the potential to boost your profits by letting your asset appreciate a bit longer.

To learn more about how taxes on investments work and how to take advantage of tax deductions, check out the tax course at Cofields Concepts (Heres our review of it). In their tax course, youll learn everything you need to know about how to take advantage of deductions and how taxes on investments work.

Capital Gains Distributions on Mutual Funds and Exchange-Traded Funds (ETFs)

Mutual funds and exchange-traded funds (ETFs) can also generate capital gains if you sell them for more than your initial investment. But they can also produce a steady stream of capital gains while you own them.

Each fund represents a portfolio of stocks. At different times during the year, the fund will sell some stocks within the portfolio. If the stocks are sold at higher prices than what they were bought for, they will produce capital gains.

Those gains will be passed on to investors in the fund through what is known as capital gains distributions.

At the end of each year, the investment company holding your fund will issue an IRS Form 1099 reporting your investment results. Form 1099-DIV will report both dividend income and capital gains distributions generated by the fund.

The amount of capital gains distributions being generated by a fund will depend on whether its a passively managed fund or an actively managed fund.

Passively managed funds engage in very little stock trading. The most common example is an index fund. Since the fund is designed to match an underlying stock index, it trades stocks only when the index changes. Index funds (typically ETFs) generate very little in the way of capital gains distributions.

An actively managed fund attempts to outperform the market. It will buy and sell stocks at opportune times. The sales will generate more frequent capital gains distributions. In a particularly actively managed account, those gains can be substantial each year.

If you sell your fund outright, and theres a gain on the sale, you will receive Form 1099-B, reporting proceeds from broker and barter transactions. (You will also receive this form reporting the sale of individual assets held through that broker.)

How Long to Hold Stock for Capital Gains

For income tax purposes, there are two types of capital gains: short-term and long-term. The tax treatment of each is radically different.

By definition, a short-term capital gain takes place when a security or asset has been held for one year or less. If you make a short-term capital gain, its added to your income and taxed at your regular income tax rate.

For example, lets say you purchase $10,000 of a particular stock in February, then sell it for $15,000 in November of the same year. Youll have a capital gain of $5,000. Since the gain is considered short-term, it will be taxed at your regular income tax rate.

If youre in the 22% tax bracket, thats the rate that will apply to the short-term capital gain. In this case, the tax liability will be $1,100 ($5,000 times 22%).

The situation is entirely different with long-term capital gains because theyre subject to lower income tax rates. By definition, a long-term capital gain is one realized after holding an asset for longer than one year. If you sell an asset one year and one day (or later) after purchasing it, it qualifies as a long-term capital gain and is subject to reduced taxation.

This benefit exists to encourage long-term investing, which creates more stability in the financial markets as well as in the prices of individual stocks.

How Much Is the Capital Gains Tax on Stocks?

As noted above, short-term capital gains are taxed at ordinary income tax rates. But there is a big reduction in federal income tax rates for long-term capital gains. This provides a major incentive to hold any investment for longer than one year.

The capital gains tax rates for 2021 can be found here.

Capital Gains Help You Build Wealth Over Time

Between the growth in value of the stock or fund youre holding and the tax benefits of lower long-term capital gains tax rates, its easy to see why capital gains are one of the most important wealth-building strategies for the average investor.

The benefit is multiplied when capital–gains–generating assets are held in tax-sheltered retirement plans. There, the investments can continue to grow without being reduced by taxes, generating even more growth.

And with the tax deferral of either tax-sheltered retirement plans or funds for the very long term, the tax liability can be put off almost indefinitely. And when the day comes that you begin taking profits, you can do it in very small increments and with a very small tax liability.

If youre able to delay those withdrawals until youre retired and are presumably in a lower tax bracket due to a reduced income, the ultimate tax rate on those gains will be either very low or even zero.

Is there any wonder why capital gains have become the primary wealth-building vehicle for the average investor?

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