Short-Term versus Long-Term Capital Gains
As most of us living in the United States already know, we Americans pay a different amount in taxes depending on how long we hold onto our investments.
For instance, if we hold an investment for one year or less, then we pay a short-term capital gains tax. Otherwise, if we hold an investment for more than a year, then we pay a long-term capital gains tax. Typically, the short-term capital gains tax is much higher than the long-term capital gains. The reasoning for this difference is to minimize short-term speculative investments to better stabilize the economy. Whether this works or not, I’ll leave to you and economists to figure out.
I was interested in knowing what percentage a short-term investment would need to make in order to compete with a long-term investment.
For instance, most people are in the 15% tax bracket for long-term capital gains tax, and most people are in the 33% tax bracket for the short-term capital gains tax. Assuming these tax percentages, what short-term investment would be equivalent to a long-term investment that earned 5%, such as a typical certificate of deposit?
Let’s do the math. Let’s say we invest $100 in a one year certificate of deposit earning 5%. At the end of the year, there would be a total of $105 in the account or $5 more than we put in. Therefore, we would need to pay 15% in taxes on the $5 and that would be exactly $0.75. This would make a $4.25 profit. Now, let’s calculate what earning percentage would be necessary to be equivalent with the 33% short-term tax rate. Basically, that means 67% of the total amount earned would have to equal to the same $4.25 profit. In other words, it would be necessary to earn about $6.34 or 6.34% to compensate for the higher tax bracket for short-term investments. Note that this scenario does not consider state taxes, sales charges, or fees.
Let’s compare several growth rates between short and long-term capital gains rates and different annual percentage yields for different types of investments.
| Example | Long-Term Tax Rate | Long-Term Growth Rate | Short-Term Tax Rate | Short-Term Growth Rate |
|---|---|---|---|---|
| #1 | 15% | 5% | 33% | 6.34% |
| #2 | 15% | 8% | 33% | 10.15% |
| #3 | 15% | 10% | 33% | 12.69% |
| #4 | 15% | 12% | 33% | 15.22% |
Therefore, as you can see, short-term investments must have a higher return just to guarantee the same profit over long-term investments.
If you want to calculate your own investment rates with different tax rates, here is the equation that you will need:
| Short-Term Growth Rate = | (100 - Long-Term Tax Rate) * (Long-Term Growth Rate) ————————————————————————— (100 - Short-Term Tax Rate) |
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For example, if we plug in the numbers from Example #1, we would get:
| Short-Term Growth Rate = | (100 – 15) * (5) ———————— = (100 – 33) |
85 * 5 ————— = 67 |
6.34 |
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Otherwise, you can use this online form:
I hope this article will help you with your investments.
by Phil B.