You might also generate a tax bill, albeit one that doesn't bite as sharply as the income tax.
A capital gain or loss is the difference between the price at which you sold your investment and its cost-basis, which is typically the price you paid for it.
Accounting for Capital Gains and Capital Losses
Capital losses can be used as a deduction against any capital gains you have taken in any given year. The deduction is limited to $3,000 in any single year. If your losses are greater than that, you can bank any amount over $3,000 to offset gains in upcoming years.
Capital gains tax rates, meanwhile, are lower than income tax rates, so you'll be taxed more lightly on your investment gains than you are on your salary.
If your income puts you under the 25% federal tax bracket -- for joint filers, under $65,100 for the 2008 tax year or $67,900 for the 2009 tax year; for singles, under $32,550 in 2008 or $33,950 in 2009 -- your capital gains tax rate is 0%. You can't do better than that.
If your income rises above that level, capital gains will be taxed at 15%. Your regular income tax rate, meanwhile, could grow to 35% at the highest income levels.
That's a huge break for investors. Add to that the fact that, unlike your salary, you can choose when to take capital gains income -- you don't have any until you sell -- and the tax advantages blossom further.
Special Cases
If you inherit your investments, your cost-basis is "stepped up" to their price on the day of the original owner's death, which means that any gains the original owners enjoyed during their lifetime are passed along to you tax-free.
Any capital gains you realize by selling investments inside a retirement account are taken tax-deferred. Which is good, in the short term. But when you take money out of any type of retirement account except a Roth IRA, it is taxed as regular income, with the rates that come with that classification.
