Investing your hard-earned cash is inherently risky. However, the risks you take vary depending on a variety of factors – one of the most prominent being the length of time you wish to keep your money out of your pocket and in the stock market.
Before you invest your money, you should know and understand the risks involved with both short- and long-term investments.
Capital gains are simply the income you earn from an investment. You find it by subtracting the amount invested from the amount you ended up with. If you invest $500 and cash out $600, you’ve made $100 in capital gains. When calculating capital gains, you don’t take other factors – such as taxable income – into consideration just yet. However, it’s beneficial to have a good idea of where you will stand once you do factor in taxes.
Short-term investments are those which last less than a single year. Because they last for a short period of time, they often won’t earn you too much money – unless you’re working with short-term, high-yield investments. In exchange for smaller rewards, though, short-term investments are usually much less risky. Short-term investments are usually finite in that investors will set a goal for how much they want to earn, and will “cash out” once they hit their goal.
The capital gains from short-term investments are lumped in with the investor’s regular income – no matter how large or small these gains may be. When it comes to paying income tax, the gains you’ve made on investments may drastically affect what tax bracket you land in, and how much you owe.
Long-term investments, by definition, are those which last for at least one year – and can stay open for as long as the investor chooses. Since long-term investments require leaving the money you invested out of your own pocket for longer periods of time, they’re much more risky than their short-term counterparts. You’ll also usually reinvest your capital gains into your long-term investments, as well. However, the gains you receive once you decide to sell tend to be much greater.
The capital gains from long-term investments stand alone as far as taxation is concerned. The money you make from them has no bearing whatsoever on your income tax.
As previously mentioned, the amount you are taxed on investments depends on if you intend to invest for a short or long period of time. It’s incredibly important to keep this in mind when deciding how to invest your money, because the tax you’ll pay may drastically affect your bottom line, and making potentially large capital gains not worth the investment in the first place.
Because short-term investments are lumped in with the rest of the money you make in a year, there’s no specific tax rate for investments that last less than a year. However, the money you make on a short-term investment may actually end up costing you in the long run. For example, if you made $37,000 in 2016, your tax rate is 15% – owing roughly $5,550. However, if you make an extra $700 from a short-term investment, you’ll be pushed up into the 25% tax bracket – meaning you’ll owe $9,425. While a $700 up front gain might seem enticing, you’ll end up losing almost $3,500 in the process.
On the other hand, since long-term investments aren’t lumped in with the rest of your income, it’s much easier to figure out how much you’ll owe in taxes on your capital gains. While the most you’ll pay is 20% of your investment capital, if you only make 15% profit on your investment, you won’t owe any tax at all. In exchange for a lower tax rate, though, you’ll be keeping your money “on the table” for a much longer period of time – meaning you’ll be risking it for longer.
Short-term investments are good for a quick win, and allow you to take your money out immediately if you choose to do so. They’re the best option if you don’t want to become too involved with the market, and are positive you’ll quit as soon as you hit a specific dollar amount.
On the other hand, short-term investments may cause more harm than good if you’re on the cusp of a certain tax bracket. Unfortunately, this is considerably counterintuitive to the purpose of a short-term investment. Most newcomers to the stock market looking to make a “quick kill” are doing so because they need some extra income immediately, but the system is set up to discourage people from making such investments. If you’re going to make a short-term investment, make sure you have capital to invest that the gains you make are worth the extra taxes you’ll end up paying.
Long-term investments have the potential to drastically increase your net worth, as long as you’re patient. If you keep your investment open for longer than a year, you won’t have to worry about being bumped up into a tax bracket that you can’t afford to be in. Additionally, if you happen to lose any of your capital over the course of your investment, you may be able to claim these losses come tax season.
However, it (obviously) takes longer to reap the rewards of a long-term investment. Long-term investments are those made with the understanding that you don’t need the money right away, and are willing to go without for some time while your investment capital grows. You’ll also have to patiently wait out any dips in the economy, during which your investment may decrease heavily in value.
As long as you can afford to lose the money you put in, long-term investments end up being the much smarter bet.
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