What it is:
How it works (Example):
The formula for taxable gain is:
Sale Price - Purchase Price = Taxable Gain
Let's assume you purchase 100 shares of Company XYZ for $1 per share. After three months, the share price increases to $5, and you sell your 100 shares for $500. Your taxable gain is $500 - $100 = $400.
Why it Matters:
The IRS considers nearly every asset owned by individuals and companies as capital assets and thus subject to capital gains taxes. Taxpayers report capital gains on IRS Schedule D, but these gains are subject to different tax rates depending on whether they are short term or long term gains (and in some cases depending on the type of asset).
In the example above, if you sold Company XYZ shares after one year, the IRS would consider your $400 profit a long-term capital gain and you would be taxed at the long-term capital gains rate. However, if you sold the Company XYZ shares less than one year after you bought them, the IRS would consider your $400 profit a short-term capital gain and you would be taxed at your ordinary income tax rate.
Some retirement vehicles, such as 401(k)s and IRAs, protect you from having to pay capital gains when you buy and sell assets within the account. This "tax deferral" is a huge benefit, because you're able to compound returns over time without the deleterious effects of taxes.