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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, Iíll 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?

Letís do the math. Letís 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, letís 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.

Letís 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%
Table #1

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)

For example, if we plug in the numbers from Example #1, we would get:

Short-Term Growth Rate  = (100 Ė 15) * (5)
 ————————  =
(100 Ė 33)
85 * 5
 —————  =

Otherwise, you can use this online form:

    Enter your Long-Term Tax: %

    Enter your Long-Term Rate: %

    Enter your Short-Term Tax: %

Your Short-Term Rate is: %

I hope this article will help you with your investments.

by Phil for Humanity
on 01/11/2008

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