When you hold an investment asset, there are usually two ways to earn a return on your investment. The first is through income payments, such as interest and dividends. The second is through an increase in the value of that asset, which is recognized as a gain — a capital gain — when it’s sold.

With the dramatic rise in the value of financial assets over the past decade, capital gains have come to replace dividends as the primary source of returns on securities. For that reason, let’s dive into the more technical aspects of capital gains.

What Are Capital Gains on Stock?

A capital gain is the increase in the value of a capital asset. That asset could be just about anything, but most typically relate to either real estate or financial assets such as stocks, bonds, and mutual funds.

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As I mentioned above investments typically produce returns either through fixed-income payments, such as interest and dividends or through capital gains. And just like interest and dividends, capital gains usually trigger a taxable event.

Let’s say you purchase 100 shares of stock at $50 per share, for a total investment of $5,000. Six months later, the price of the stock rises to $65 per share. You sell your entire position for $6,500, producing a $1,500 gain on sale.

The $5,000 purchase price of the stock represents your cost basis. The $1,500 gain represents a capital gain.

One important distinction with capital gains relates to realized and unrealized gains. The example given above represents a realized capital gain. That’s because the stock has been both bought and sold, and the gain has been received.

If the same situation were to occur, but you didn’t sell the stock, the gain would be unrealized. This is sometimes referred to as a paper gain, because it exists only on paper and hasn’t been received in the form of cash.

Only a realized capital gain is taxable, because the proceeds have actually been received.

If your stock position grows from $5,000 to $50,000 over five years but you don’t sell the stock, the gain is not taxable, because the profit has not actually been received yet.

Capital Gains Distributions on Mutual Funds and Exchange-Traded Funds (ETFs)

Mutual funds and exchange-traded funds (ETFs) can also generate capital gains if you sell them for more than your initial investment. But they can also produce a steady stream of capital gains while you own them.

Each fund represents a portfolio of stocks. At different times during the year, the fund will sell some stocks within the portfolio. If the stocks are sold at higher prices than what they were bought for, they will produce capital gains.

Those gains will be passed on to investors in the fund through what is known as capital gains distributions.

At the end of each year, the investment company holding your fund will issue an IRS Form 1099 reporting your investment results. Form 1099-DIV will report both dividend income and capital gains distributions generated by the fund.

The amount of capital gains distributions being generated by a fund will depend on whether it’s a passively managed fund or an actively managed fund.

Passively managed funds engage in very little stock trading. The most common example is an index fund. Since the fund is designed to match an underlying stock index, it trades stocks only when the index changes. Index funds (typically ETFs) generate very little in the way of capital gains distributions.

An actively managed fund attempts to outperform the market. It will buy and sell stocks at opportune times. The sales will generate more frequent capital gains distributions. In a particularly actively managed account, those gains can be substantial each year.

If you sell your fund outright, and there’s a gain on the sale, you will receive Form 1099-B, reporting proceeds from broker and barter transactions. (You will also receive this form reporting the sale of individual assets held through that broker.)

How Long to Hold Stock for Capital Gains

For income tax purposes, there are two types of capital gains: short-term and long-term. The tax treatment of each is radically different.

By definition, a short-term capital gain takes place when a security or asset has been held for one year or less. If you make a short-term capital gain, it’s added to your income and taxed at your regular income tax rate.

For example, let’s say you purchase $10,000 of a particular stock in February, then sell it for $15,000 in November of the same year. You’ll have a capital gain of $5,000. Since the gain is considered short-term, it will be taxed at your regular income tax rate.

If you’re in the 22% tax bracket, that’s the rate that will apply to the short-term capital gain. In this case, the tax liability will be $1,100 ($5,000 times 22%).

The situation is entirely different with long-term capital gains because they’re subject to lower income tax rates. By definition, a long-term capital gain is one realized after holding an asset for longer than one year. If you sell an asset one year and one day (or later) after purchasing it, it qualifies as a long-term capital gain and is subject to reduced taxation.

This benefit exists to encourage long-term investing, which creates more stability in the financial markets as well as in the prices of individual stocks.

How Much Is the Capital Gains Tax on Stocks?

As noted above, short-term capital gains are taxed at ordinary income tax rates. But there is a big reduction in federal income tax rates for long-term capital gains. This provides a major incentive to hold any investment for longer than one year.

The capital gains tax rates for 2019 are as follows:

Long-Term Capital Gains Tax RateMarried Filing Jointly Taxable IncomeHead of Household Taxable IncomeSingle Filer Taxable IncomeTax Rate on Ordinary Income0%$0 to $78,750$0 to $52,750$0 to $39,375Generally, 10% to 12%15%$78,751 to $488,850$52,751 to $461,700$39,376 to $434,550Generally, 22% to 35%20%$488,850 and above$461,700 and above$434,550 and above35% to 37%

As you can see from the table above, the tax savings for long-term capital gains is incredibly generous. If you’re married filing jointly and your taxable income (after deductions and exemptions) is $75,000, your income will be taxed at 12%. But you pay zero long-term capital gains tax.

If you’re married filing jointly and your taxable income is $100,000, your regular income will be taxed at 22%, but you pay just 15% on long-term capital gains.

How to Avoid Capital Gains Tax on Stocks

There are probably at least a dozen ways to avoid capital gains tax on stocks, but we’re going to focus on the three most common.

1. Hold appreciating assets in a tax-sheltered retirement plan.

This can include a traditional or Roth IRA, a 401(k) or 403(b) plan, or a SEP IRA or SIMPLE IRA. Since each plan features deferral of investment income, any capital gains realized within the plan will not be subject to immediate taxation. This includes both short-term and long-term capital gains.

Technically speaking, the capital gains tax will never specifically be applied to these transactions. Funds held in a tax-deferred retirement plan don’t become taxable until they’re withdrawn. And once they are, they’re taxed at regular tax rate. But you’ll largely be able to control the tax liability by limiting the size of the withdrawals you take from any of these plans.

2. Offset capital gains with capital losses.

The IRS allows you to deduct capital losses from capital gains before calculating your capital gains tax liability. We’re not going to get deep into this discussion since it is covered in a separate article. But basically, if your investment portfolio generates $20,000 in capital gains, but you also have $12,000 in capital losses, your net capital gains subject to tax is just $8,000.

Offsetting capital gains with capital losses is even a formal investment strategy, known as tax-loss harvesting. It’s a common practice with robo-advisor investment platforms.

3. Don’t sell your investments.

Remember earlier we said a capital gain doesn’t become taxable until the investment is sold and the profit is realized? If you never sell the asset, it can continue to grow in value without creating a tax liability. This is a form of backdoor tax deferral, similar to tax-sheltered retirement plans.

Naturally, this strategy will work best with investments in companies with very strong long-term growth and income prospects. In theory, at least, you can hold the stock for 20 years and watch it grow in value by tenfold and never incur capital gains tax.

But a more conventional way to do this is with index-based ETFs. Since stocks in the fund are rarely sold, the ETF can continue to build in value as the years’ pass. Later, when you may need to draw income from the fund, you can begin taking it in small amounts. Those small withdrawals will also limit your capital gains income from the sale of portions of the ETF.

That will not only minimize the tax but also defer the liability until well into the future. And since selling a portion of an ETF is like selling stock, the sales will get the benefit of lower long-term capital gains tax rates.

Capital Gains Help You Build Wealth Over Time

Between the growth in value of the stock or fund you’re holding and the tax benefits of lower long-term capital gains tax rates, it’s easy to see why capital gains are one of the most important wealth-building strategies for the average investor.

The benefit is multiplied when capital-gains–generating assets are held in tax-sheltered retirement plans. There, the investments can continue to grow without being reduced by taxes, generating even more growth.

And with the tax deferral of either tax-sheltered retirement plans or funds for the very long term, the tax liability can be put off almost indefinitely. And when the day comes that you begin taking profits, you can do it in very small increments and with a very small tax liability.

If you’re able to delay those withdrawals until you’re retired and are presumably in a lower tax bracket due to a reduced income, the ultimate tax rate on those gains will be either very low or even zero.

Is there any wonder why capital gains have become the primary wealth-building vehicle for the average investor?