Like HowStuffWorks on Facebook!

How Capital Gains Tax Works

Lowering Your Capital Gains Tax
One of the best ways to lower your capital gains taxes is to sock money away in a 401(k).
One of the best ways to lower your capital gains taxes is to sock money away in a 401(k).
Don Farrall/Photodisc/Getty Images

The simplest strategy for lowering the amount you owe in capital gains tax is to avoid short-term investments. Long-term investments will almost always have a lower tax rate than short-term investments. In the case of the lowest tax brackets, you'll pay nothing for long-term capital gains on most securities.

Capital gains tax should always be considered when making an investment in stocks or other securities. It might seem smart to make a short-term investment with a higher interest rate than a long-term investment with a lower rate. But after capital gains tax is collected, that long-term investment might leave more profit in your pocket.

Another strategy for avoiding high capital gains taxes is to shelter as much income as possible in tax-deferred retirement accounts like 401(k)s, Roth IRAs and Traditional IRAs. The cool thing about these accounts is that you can buy, sell and exchange securities within the account without being charged any capital gains tax. These accounts shelter your investments from capital gains tax as long as any money earned from a sale is reinvested in another security.

When you begin to withdraw money from a retirement account -- after you've reached retirement age -- you'll be taxed at your normal income tax bracket. The advantage here is that when you're retired, you'll probably be in a lower tax bracket than when you were working [source: Investopedia].

The final strategy for lowering your capital gains tax burden involves those capital losses we mentioned before. If you sell an asset for less than its original purchase price, that's a capital loss. You can subtract, or deduct, capital losses from your capital gains to lower your total taxable earnings. A smart strategy is to sell any investments that are losing money within the first year. That way you won't have to pay a high, short-term capital gains tax if they somehow start to earn money.

Interestingly, unlike capital gains, you don't have to apply capital losses to the tax year in which they occurred. It's legal to carry over losses from the current year to one of the next seven years of tax returns. This way you can wait for an especially high capital gains year to use the capital loss deduction.

For more information on investing and personal finances, take a look at the links on the next page.

More to Explore