TL;DR
- The amount of capital gains tax that an investor incurs is based on how long the investment was held before being sold, the investor’s income, and the investor’s tax filing status.
- Federal income tax rates apply to assets that are sold after being held for less than a year, while long-term capital gains tax rates apply to assets that are sold after being held for more than a year.
- Investors may hold on to investments and dividend-paying stock for longer periods of time to avoid larger taxes
- Many investors choose to put funds in education and retirement accounts because of tax benefits.
- Specific 1099 forms must be filed with the IRS when an investor receives income from an investment. These forms are often provided by a broker to individual taxpayers.
Investing in the stock market is a great way to build wealth, but there are tax implications that should be considered before starting on any investment journey. Gains on investments can be taxed in a variety of ways depending on the account being used and the length of time the investment is held. While it is near impossible to avoid taxes completely, there are ways to minimize the amount of taxes you pay on your investments.
Capital gains tax
The profit or loss that results from the sale of an asset is often referred to as a capital gain or a capital loss. Assets can be anything from investments, like stocks and bonds, to physical land. Anytime money is made on the sale of an asset, profits are subject to something called a capital gains tax. Capital gains are classified as either long-term or short-term depending on how long the asset is held before being sold. The length of time an asset is held in conjunction with a couple of other factors will determine an investor’s capital gains tax rate.
Capital gains vs. federal income tax
A few factors determine the rate at which capital gains are taxed: how long the investment was held before being sold, the investor’s income, and the investor’s tax filing status. If an investment is held for less than a year, it is subject to the investor’s federal income tax rate. An investor’s income tax rate is determined by the investor’s income bracket, but it is always less favorable than the long-term capital gains tax. If an investment is held for more than a year, an investor’s income and tax filing status will determine which of the three capital gains tax rates apply: 0%, 15%, or 20%.
What are stock dividends?
When you buy a share of a company, you become a shareholder or partial owner. Often, when a company is doing financially well, it will reward shareholders with regular payments of cash or additional stock, known as dividends. While dividends are considered income, they are subject to different tax implications.
Learn more about how dividends work here.
Taxing stock dividends
Whether a cash dividend is qualified or non-qualified will determine what tax structure will apply. A dividend is considered qualified if common stock is held for a minimum of 60 days or preferred stock is held for a minimum of 90 days before the ex-dividend date. If a dividend is qualified it is subject to the capital gains tax rate which, as mentioned, is considerably less than the federal income tax rate. If a dividend is non qualified, the capital gains tax does not apply and it is subject to the investor’s federal income tax rate. Therefore, for the diligent investor, dividends can provide great tax opportunities. Additionally, if you receive dividends in the form of stock, taxes do not apply until stock is sold and gains are recognized.
How to minimize taxes on stock and dividends
Capital gains taxes should be taken into consideration when investors think about where to invest their money and when to sell securities. Certain retirement and education investment plans present tax benefits for someone interested in creating a long-term investment portfolio. For example, if investors set up a 401(k) retirement plan, a traditional Individual Retirement Account (IRA), or a 529 education plan they can buy and sell investments within a tax-free environment. While there is often a tax upon withdrawal from these accounts, it is still extremely beneficial and efficient to build a long-term portfolio within a tax-free environment.
If you decide to buy and sell securities within a traditional investment account, it may be beneficial to hold on to stocks for longer than a year to avoid the unfavorable income tax on short-term capital gains. Similarly, to avoid paying federal income tax on dividends, investors may decide to hold on to dividend-paying common stock for a minimum of 60 days. While this will not avoid taxes completely, it will allow the investor to benefit from the lower capital gains tax rate.
Learn more about tax loss harvesting here.
Tax forms
When reporting income from investments like stocks, bonds, and dividends to the IRS (Internal Revenue Service) 1099 forms will be necessary. There are many different types of 1099 forms, but luckily individual taxpayers rarely have to fill them out. The forms are often provided to the taxpayer by a broker.
- 1099-B, which reports capital gains and losses.
- 1099-DIV, which reports stock or mutual fund dividend payments.
- 1099-R, which reports distributions from retirement plans, IRAs, and pensions.
While the forms are often provided to individual taxpayers when necessary, it is important to keep your own record of any investment income so it is properly reported to the IRS.
Bottom line
Many investors take the potential impact of taxes into consideration when deciding how to handle their investments. An investor’s long-term capital gains tax is more favorable than an investor’s federal income tax, regardless of income or filing status. Therefore, investors may decide to hold on to securities for longer than a year to reap the benefits of the lesser rate associated with a long-term capital gains tax. Some investors who are trying to build a long-term portfolio may opt to avoid short-term taxes by setting up a retirement or education account. All investors want to ensure that their investments are as profitable as they can be. To do this, it is necessary to think about the effect of taxes on capital gains. Taxes are unavoidable, but there are ways to minimize their impact.