The Internal Revenue Service taxes different kinds of income at different rates. Capital gains, such as profits from a stock sale, are generally taxed at a more favorable rate than your salary or wages. However, not all capital gains are treated equally. The tax rate can vary dramatically between short-term and long-term gains. Generating gains in a retirement account, such as a 401(k) plan or an IRA, can also affect your tax rate.
Short-term capital gains
Short-term capital gains do not benefit from any special tax rate – they are taxed at the same rate as your ordinary income. For 2014, ordinary tax rates range from 10 percent to 39.6 percent, depending on your total taxable income.
If you sell an asset you have held for one year or less, any profit you make is considered a short-term capital gain. The clock begins ticking from the day after you acquire the asset up to and including the day you sell it.
Long-term capital gains
If you can manage to hold your assets for longer than a year, you can benefit from a reduced tax rate on your profits. For 2014, the long-term capital gains tax rates are 0, 15, and 20 percent for most taxpayers. If your ordinary tax rate is already less than 15 percent, you could qualify for the zero percent long-term capital gains rate. For high-income taxpayers, the capital gains rate could save as much as 19.6 percent off the ordinary income rate.
Gains in retirement accounts
One of the many benefits of IRAs and other retirement accounts is that you can defer paying taxes on any gains. Whether you generate a short-term or long-term gain in your IRA, you don't have to pay any tax at all until you take the money out of the account. The negative is that all contributions and earnings you withdraw from an IRA, even profits from long-term capital gains, are taxable as ordinary income. You gain the benefit of tax-deferral but lose the benefit of the long-term capital gains tax rate.
If your investments end up losing money, rather than generating capital gains, you can use those losses to reduce your taxes. The IRS allows you to match up your gains and losses for any given year to determine your "net" capital gain or loss. If you end up with a net loss, you can use up to $3,000 per year to reduce your taxable income. Any additional losses can be carried-forward into future years, to offset either capital gains or another $3,000 in ordinary income.
Since you don't generate capital gains or losses in a retirement account, you can't use trades in IRAs or 401(k) plans to offset your income in this manner.