The concept of capital gains is simple. Sell an asset for more than the purchase price, and the profit is what the IRS considers a capital gain. For investors, these gains typically come from buying and selling stocks, mutual funds, ETFs, or other securities. When a capital gain is realized, it incurs a tax liability. However, all capital gains aren’t taxed at the same rate.
The way the tax code handles capital gains can significantly affect investment outcomes. Understanding the rules is essential because the tax rate can make the difference between a potentially good return and a great one.
Let’s look at the basics of capital gains taxes, how they impact a portfolio, and why a long-term mindset, paired with the appropriate investment vehicles, can help investors seeking to maximize wealth over time.
What are capital gains taxes?
While the capital gains we’re most concerned with here are those that come from the profitable sale of securities, other assets such as real estate, art, antiques, classic cars, and cryptocurrency can also generate taxable capital gains when sold at a profit. However, tax rules and rates for other assets can vary. For example, joint filers who realize a capital gain on selling their primary home may exclude up to $500,000 from their income if certain conditions are met.1 For our purposes, we’ll focus on marketable securities.
The capital gains tax is what an investor must pay the government on the profits from selling a security. The tax is payable only when the asset is sold. For example, if an investor buys a stock at $50 and the price rises to $150, the $100 difference is an unrealized gain until the stock is sold. The Internal Revenue Service (IRS) does not tax unrealized gains. Tax is due only when the paper profit becomes a real profit.
A tale of two timelines: short-term vs. long-term
Now, not all capital gains are created equal. The IRS uses a simple calculation to determine how much profit an investor gets to keep. The magic number is one year.
Short-term capital gains apply to assets held for one year or less. The government views short-term buying and selling as similar to income. Therefore, short-term capital gains are taxed at the ordinary income tax rate, ranging from 10% to as high as 37%. For the highest tax bracket, the short-term capital gains rate can take a massive bite out of returns.
Long-term capital gains apply to assets held for more than one year prior to sale. The government actively encourages long-term investment in the economy by rewarding investors who hold stocks longer with significantly lower tax rates. Federal long-term capital gains rates are 0%, 15%, or 20%, depending on the investor's taxable income and filing status. High earners may also be required to pay a 3.8% additional Net Investment Income Tax (NIIT).2
A little patience can pay off
To see an example in the real world, let’s look at two hypothetical investors, Cody and Tristan.
Both investors buy $10,000 worth of an unnamed stock. Both see their investment appreciate to $20,000, giving each of them a $10,000 profit. Both Cody and Tristan are taxed at 32% on their ordinary income.
Cody is nervous about market volatility and sells his shares after 11 months. Because he held the stock for less than a year, his $10,000 profit is taxed at his ordinary income rate of 32%. He owes the IRS $3,200 and realizes a profit of $6,800.
Tristan is more patient. He holds his shares for 13 months before selling. Because he held the stock beyond the one-year threshold, his profit is taxed at the long-term capital gains rate of 15%. Tristan owes the IRS $1,500 and realizes a profit of $8,500.
Tristan made exactly the same investment and earned exactly the same return, but he walked away with an extra $1,700 just by waiting two more months. This is a tangible reward for patience.
The ETF advantage: A built-in tax shield
Understanding tax rates is only half the battle. The investment vehicle matters just as much.
For years, mutual funds were the default choice for retail investors. Unfortunately, mutual funds have a structural flaw when it comes to taxes. When a mutual fund manager sells a stock within the fund for a profit, the capital gain is passed on to you, the shareholder. Depending on how long you held the mutual fund, you could be hit with a capital gains tax bill at the end of the year, even if you never sold a single share of the mutual fund yourself.3
Exchange-traded funds (ETFs) work differently, because there are fundamental differences in structure and trading that typically can result in fewer capital gains distributions to shareholders. For the most part, since most transfers of securities within the ETF are transacted “in-kind” rather than via cash sales, capital gains are rarely passed on in these situations (not including when the investor sells their shares of the ETF).4
ETF shareholders can decide when to pay taxes, as the capital gains tax is only triggered when the ETF shares are sold. Consequently, ETFs are generally considered more tax-efficient, and invested funds have the opportunity to compound without unpleasant surprises from annual tax bills.
Time in the market beats timing the market
Capital gains taxes reinforce a key investing principle: success in the stock market is driven more by time in the market than by trying to time it. Not only does long-term investing benefit from compounding growth, but it also allows investors to take advantage of more favorable tax treatment on long-term capital gains.
Despite this, human nature often pushes investors in the opposite direction. When markets decline, fear can lead investors to sell in an effort to protect their cash. When markets rise, the urge to lock in profits can be just as strong. However, attempts to time the market typically can lead to two costly outcomes: missing the market’s best-performing days and incurring higher short-term capital gains taxes.
Historical data underscores this point. Looking at the long-term performance of the S&P 500, the likelihood of earning a positive return increased significantly the longer an investor remained invested. From 1928-2024, the historical annual returns of the S&P 500 show that returns were positive for the majority of the period and the index delivered an average annual return of roughly 10% over time.5
Taken together, we believe both the tax structure of capital gains and the historical performance of the market make a compelling case for long-term investing. Staying invested not only improves the odds of capturing potential growth but also helps minimize unnecessary tax burdens—further rewarding patience and discipline.
Tax efficiency was one of the key reasons we converted our mutual fund products to ETFs at Motley Fool Asset Management. We are big believers not just in the power of long-term investing, but in helping you keep as much of your gains as possible, and avoid any unpleasant surprises from Uncle Sam. Our lineup of passive and active ETFs are designed to help you invest efficiently and, of course, Foolishly! Check out our complete lineup of ETFs here.
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