The Capital Gains Tax Explained

If you turn on CNBC or any other business show which discusses the topic of investing, you'll commonly hear discussions as to how one can minimize their tax burden on their investments. Quite often people will be given a set of steps to follow just so they can avoid paying certain taxes. This is because any money paid in taxes on an investment makes the investment less valuable, so one would want to avoid them as much as possible. The most common tax on any investment in the United States is what's called the capital gains tax. Here's how it works.

What's a capital gain? A capital gain is simply the amount of money that you made off of an investment at the point when you sell it.. Let's say that you purchased a baseball card 5 years ago for $1.00, and now it's worth $5.00. Since you've grown up a bit, you've lost interest in collecting baseball cards so you decide to sell it for the $5.00 that it's worth. You would have a capital gain of $4.00 on your collectible baseball card. It's that simple.

What about capital gains taxes? Under the current US tax code, you're required to pay taxes on any capital gains that you have. The percentage that you pay on the capital gains will vary depending on the investment that you make. If the investment is held for less than one year, it's considered short term capital gains and you will have to pay your normal tax rate on the capital gains from the investment. If the investment is held for longer than one year, you will be charged a capital gains tax of 15% (or 5% if you're in the 10% bracket, or 10% if you're in the 15% bracket.)

How does one avoid capital gains? Nobody wants to pay a dime more of taxes than they have to, fortunately there are some very good ways that one can invest money for specific purposes, such as retirement and education, and avoid essentially all of the capital gains taxes. Most Americans qualify for an investment account called a Roth IRA which allows you to invest up to $4000 after-tax dollars each year into a retirement account and never pay a dime in capital gains tax on it. The $4000 number will increase to $5000 in 2008 and beyond. If you have children, you can put money away in an educational savings account for their college education which also grows tax free. Depending on where you work, you might also have options to invest in things such as 401k plans, 403b plans, and the like which are also very beneficial tax wise.

Capital gains are just part of the current tax code, and it doesn't seem like we're going to be getting rid of them anytime soon. However there are ways to minimize or possibly even eliminate your capital gains taxes if you invest your money properly.