The investment capital that you put at risk is called your principal.
It’s the amount that you start with. Your objective is to increase that amount, but as you do, you don’t want to forget that your gains are separate. Terms like principal and profit help you to separate your initial fund from your earnings. Accounting for the gains versus what you started with helps you to make decisions.
Such decisions might be in regards to how you file your taxes.
No matter how you gain it, the profits you make are taxable. If you don’t respect this, then you might find your best year of profits as equaling nothing in the end. Here’s a better look at how the government charges your investment activity and what you can do about it. In the end, your objective is to protect your principal.
What are Capital Gains
The investment gains you incur, as it relates to the taxes you file every year, are called capital gains. Investors learn about this subject in order to properly file with the IRS—without receiving penalties. Since gains are taxable according to the IRS, not filing them can lead to you being charged more than what’s deemed necessary.
Like all taxes that you file, you only have to report capital gains once a year.
This gives you the time to organize your accounts.
If you understand how these gains are filed, then you can time your filings to avoid paying taxes. Now you can only avoid tax payments for a full year, for you will, eventually, have to file your gains from the market. It’s a basic equation: Let’s say that you start with $1,000 as your investment capital, which goes up to $1,097.34.
The additional $97.34 that is within your account is taxable.
The prior $1,000, as long as that money is legal, is implied as already taxed. For example, you saved $1,000 from odd jobs that you did, which you already filed and paid taxes on. Therefore, the remaining, taxed fund you have, which equals $1,000 in this case, is used as an investing principal, so only what’s earned from it is taxed.