An earlier post mentioned that the holding period for a capital gain affects its tax rate. Short-term capital gains get taxed just like ordinary income. This rate can rise as high as 35% for taxpayers in the top bracket. For long-term capital gains, the tax rate is much lower: 15%.
The huge cost of a short-term gain
Eleven months ago, an investor bought 300 shares of stock at $40. The latest market price for the stock is $50. Her $12,000 investment is up 25% and is now worth $15,000. If she sells now, she has a $3,000 short-term capital gain.
In the top tax bracket, the gain would incur a tax of $1,050 ($3,000 times 35%). Subtracting the tax leaves an after-tax gain of $1,950. Instead of being up 25%, her after-tax return has fallen to about 16%.
Save tax if a long-term gain is near
She might wait a month or so before selling. By doing so, she does risk a fall in the market price. But after holding the stock more than a year, she may get another chance to sell the stock at $50. Such a long-term gain would have a tax of $450 ($3,000 times 15%).
Holding the unrealized gain until it became long-term has saved $600 in tax ($1,050 minus $450).
This $600 in after-tax savings amounts to 20% of the $3,000 before-tax gain. When a long-term gain is imminent, one should carefully consider the cost of selling too soon. In other words, taking a short-term gain could cost an investor 20% of their before-tax return.
Note that the Tax Increase Prevention and Reconciliation Act of 2005 extends the 15% rate for long-term capital gains only through December of 2010. Beginning in 2011, long-term capital gains will incur a 20% tax rate.