Stocks are undoubtedly one of the best ways to grow your money for retirement. However, investing in stocks is not without its risks. When you invest in stocks, there are two types of taxes that can occur. This article will cover how stocks work with taxes of the short-term and long-term variety.
Although they’re the most common form of long-term investment, there are a lot of questions surrounding how stocks work with taxes. In this article, we’ll shed some light on common concerns and provide you with some helpful information to keep in mind as you make your investment decisions.
Capital gains taxes
If you’re holding shares of stock in a regular brokerage account, you may need to pay capital gains taxes when you sell the shares for a profit. There are two types of capital gains taxes:
- Short-term capital gains tax is a tax on profits from the sale of an asset held for a year or less. Short-term capital gains tax rates are the same as your usual tax bracket. (Unclear what tax bracket you’re in? Learn about federal tax brackets.)
- Long-term capital gains tax is a tax on profits from the sale of an asset held for longer than a year. Long-term capital gains tax rates are 0%, 15% or 20% depending on your taxable income and filing status.
- Long-term capital gains tax rates are usually lower than those on short-term capital gains. That can mean paying lower taxes on stocks.
Taxes on dividends
- Dividends are usually taxable income.
- For tax purposes, there are two kinds of dividends: qualified and nonqualified. Nonqualified dividends are sometimes called ordinary dividends. The tax rate on nonqualified dividends is the same as your regular income tax bracket. The tax rate on qualified dividends is 0%, 15% or 20%, depending on your taxable income and filing status. This is usually lower than the rate for nonqualified dividends.
- In both cases, people in higher tax brackets pay more taxes on dividends.
- How and when you own a dividend-paying investment can dramatically change the tax bill on the dividends.
- There are many exceptions and unusual scenarios with special rules; see IRS Publication 550 for the details.
What Will I Owe in Taxes on My Stock Gains?
Here’s where it gets tricky. The amount you owe in taxes on your stocks will depend on what tax bracket you’re in. Short-term capital gains are taxed as ordinary income, just like your paycheck.
We don’t need to go through every bracket here (you can see which bracket you’re in here), but for most investors, the rate is tolerably low. For example, a married couple filing jointly with taxable income of $80,251 to $171,050 will be in the 22% bracket. So, if that’s you, and you earned $1,000 in the stock market, you’ll be paying $220 in capital gains taxes.
If you sold stock that you owned for at least a year, you’ll benefit from the lower long-term capital gains tax rate. In 2020, a married couple filing jointly with taxable income of up to $80,000 pays nothing in long-term capital gains. Those with incomes from $80,000 to $496,600 pay 15%. And those with higher incomes pay 20%.
There’s also a 3.8% surtax on net investment income, which applies to single taxpayers with modified adjusted gross incomes (MAGI) over $200,000 and joint filers with MAGI over $250,000. Net investment income includes, among other things, taxable interest, dividends, gains, passive rents, annuities and royalties.
The important thing to remember here is that most tax software – even the cheap ones – will generally do these calculations for you. You don’t have to remember any of this. You can just pull the numbers off the 1099-B, input them into your tax program, and voila, the program does the rest.
But perhaps it’s even more important to remember that paying taxes on your investment income isn’t the worst thing in the world. It means you made money. And while it might be painful to part with 20% or more of your earnings as taxes, just remind yourself that the remaining 80% or so is still profit that you didn’t have before.
And remind yourself to set aside money for the tax man when you enjoy gains on your stocks in the years to come.
What Are Capital Gains Taxes?
Capital gains are the profits you earn when you sell an investment for more than you paid for it. For example, if you buy 100 shares of stock X for $4,000 and sell them for $6,700, your capital gain is $2,700. Taxes on capital gains only apply to profits you make when you sell. If the value of your investments has risen but you haven’t realized any gains by selling shares, you don’t owe any taxes—yet. You’ll pay taxes on these gains whenever you sell your stocks.
Both long-term and short-term capital gains are subject to tax. Long-term capital gains taxes apply to profits you make from investments you’ve owned for more than a year. If you’ve made a profit from stocks you owned for less than a year, as many people who’ve tried their hand at day trading have, your short-term capital gains are taxed as ordinary income.
How to Lower Your Taxes on Stocks
Long-term capital gains generally have a tax advantage over short-term gains. One way to minimize your capital gains tax bill is to hold on to investments for at least a year before selling them. Your broker (or brokerage software) should track this information to help you avoid selling stocks before their time.
What if you’re successfully making money on short-term gains? Even if your income puts you in a high tax bracket, short-term capital gains still put money in your pocket. As long as you’re setting aside enough for taxes and paying your tax bills on time, short-term profits are a net positive.
Then again, most of us prefer a lower tax bill to a higher one. A few more ideas for keeping your tax bill down:
- Invest money in retirement and college savings. Funds that are held in 401(k) and IRA retirement accounts aren’t taxed until you withdraw money, generally in retirement. Any profitable trades you make within an account aren’t taxed. Money in a Roth IRA is never taxed, even when withdrawn; the same is true for 529 education accounts, as long as withdrawals are spent on qualified expenses. So, if you’re investing for the future and you’d like to keep your capital gains tax bill down, buying and selling stocks within your retirement plan or 529 plan is an option.
- Offset gains with losses. When you sell stocks for less than you paid for them, the loss you incur can help offset your taxable gains.
- Sell when your income is low. Another strategy: Sell profitable stocks when your income is lower, either because you’ve retired or you’ve had a “down” year. Remember: If your income is below $40,400 for a single person, or $80,800 for married people filing jointly, your long-term capital gains tax rate is zero.
How to pay lower taxes on stocks
Think long term versus short term
- You might pay less tax on your dividends by holding the shares long enough for the dividends to count as qualified. Just be sure that doing so aligns with your other investment objectives.
- Whenever possible, hold an asset for a year or longer so you can qualify for the long-term capital gains tax rate when you sell. That tax rate is significantly lower than the short-term capital gains rate for most assets. But again, be sure that holding the investment for that long aligns with your investment goals.
Use investment capital losses to offset gains
The difference between your capital gains and your capital losses is called your “net capital gain.” If your losses exceed your gains, you can deduct the difference on your tax return, up to $3,000 per year ($1,500 for those married filing separately).
Hold the shares inside an IRA, 401(k) or other tax-advantaged account
- Dividends and capital gains on stock held inside a traditional IRA are tax-deferred, and tax-free if you have a Roth IRA; dividends and capital gains on stocks in a regular brokerage account typically aren’t.
- Once money is in your 401(k), and as long as the money remains in the account, you pay no taxes on investment growth, interest, dividends or investment gains.
- You can convert a traditional IRA into a Roth IRA so that withdrawals in retirement are tax-free. But note, only post-tax dollars get to go into Roth IRAs. So if you deducted traditional IRA contributions on your taxes and then decide to convert this to a Roth, you’ll need to pay taxes on the money you contributed, just like everyone else who invests in a Roth IRA. Backdoor Roths generally work better for people who will be in a higher tax bracket in retirement than they are now.
Conclusion
There are different types of securities available for stock markets – stocks, options and warrants. Each one of these securities has a different structure, and thus the tax implications and benefits vary as well at each level. Given the differential nature of these securities, an investor must be aware of how they work with his/her taxes. Let us delve deeper into the same now.