Income Vs. Capital Gains Tax: Encouraging Investment

The capital gains tax is an income tax on all capital gains made by individuals and corporations. It is intended to encourage investors to make capital investments and fund entrepreneurial activities. It often overlaps with other types of income tax, particularly personal and corporate income taxes.

Income Taxes and Investments

Income tax is a tax levied against different types of income. This includes personal income, corporate income, employee payrolls, inheritance and anything earned when one buys or sells investments. For the most part, income taxes increase in proportion to the amount earned. Naturally, many investors feel that income taxes penalize them for trying to make bigger profits. This is one of the reasons why they are reluctant to invest in ventures where profitable returns aren't guaranteed. That, in turn, puts a federal government in the bind. On one hand, investments stimulate the economy, so it wants the investors to invest as much as possible. On the other hand, it needs to generate funds for its programs, and that requires taxes.

Capital gains tax presents a compromise. While it still chips away at the investors' profits, the tax law is structured in a way to encourage investment.

Capital Gains Taxes and Investments

Capital gains are profits made when investors sell capital assets - stocks, bonds, mutual funds, precious metals and property - and earn more than what they originally paid for it. They can be divided into short term and long term capital gains, depending on how long the investors hold into them before selling them. The short term gains are gains made when the assets are held for no longer then a year. Long term gains are gains made over any period beyond that.

The current tax laws have several provisions that encourage investors to hold on to their capital assets for a long term. Investors pay the capital gains tax whenever they sell capital assets. This gives investors an incentive to hold the investments as long as possible.  Ideally, this means that the value of their investments grow in value, which means that they would benefit on the long run.

If the investor is in a 25% income bracket or higher, the maximum capital gains tax rate is limited to 15 percent of the gains' value. This means that he or she would have to pay the government the same portion of the money, regardless of how much they earn. By contrast, if he or she makes short-term gains, the tax rate increases in proportion to their value. This is another reason why investors who avoid selling off their assets in a hurry would earn more on the long term.

Avoiding Capital Gains Taxes

The current tax laws also allow investors to avoid paying capital gains taxes altogether. This can be done in two ways:

Putting their assets towards retirement - investors can place their investments in retirement savings accounts such as the 401(k)s. The downside of it is that the investors would not be able to use this money until they retire. On the other hand, if managed right, this can leave them with a hefty income.

Giving their assets to charity - if investors donate their long term capital assets to charity, neither they nor the charity in question have to pay taxes on them. Not all charities accept assets as donations, but if they do, investors can avoid paying taxes while doing something positive for the community.
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