Understanding Capital Gains in Your Investment Portfolio

If you have a large balance in a taxable investment account, you may have been surprised by significant capital gains taxes this year.  This can be especially confounding in a year that stock market returns were negative, and you didn’t sell anything.

Capital gains taxes must be paid on gains in taxable, non-retirement accounts, in the year they are earned.  The category of capital gain tax depends on how long you own the security. If you own a security for less than one year, gains are treated as a short term and securities held for over a year are treated as long term.  Short term capital gains are taxed at your ordinary income tax rate.

Taxes on long term capital gains and qualified dividends are progressive - a higher tax rate is imposed on those with a higher income.  Prior to the Tax Cuts and Jobs Act (TCJA) there were three tax rates on long term capital gains and qualified dividends, 0%, 15% and 20% that were tied to ordinary income tax brackets.  Under the TCJA there are still three rates but they they are based on taxable income rather than tax brackets. For example, in 2019 if you are a joint filer with taxable income between $0 and $78,750 your rate is 0%, if your taxable income is between $78,751 and $488,850 your tax rate is 15% and if your taxable income is above $488,850 your tax rate is 20%.

As a result of the Affordable Care Act, high income tax payers must pay an additional 3.8% Net Investment Tax or Medicare tax on capital gains, dividends and interest.   Individuals with modified adjusted gross income of over $200,000 and joint filers with over $250,000 must pay long term capital gains rates plus an additional 3.8%.

Capital gains are triggered when you sell a security or when stocks are sold within a mutual fund that you own.  Mutual funds do not pay taxes, the taxes are passed on to the investor.  If a mutual fund sells a stock for a gain you will have to pay tax on this gain even if the annual return on your fund was negative and you didn’t sell any shares of the fund.  When you pay taxes on gains within a mutual fund you receive credit for this when you ultimately sell the fund.  The gains are added to your cost basis.

You don’t pay capital gains on securities held in an IRA, 401k or other type of retirement account.  Gains earned on stock and mutual funds held in retirement accounts build up within your account overtime.  With exception to Roth accounts, when you take distributions you will pay tax at ordinary income tax rates on the full value of your distribution.  Since you didn’t pay taxes on the initial investment or on gains as they were earned, the entire value of the account is taxable.