Uncle Sam always finds a way to get his share, and the stock market is not immune. Everyone has to pay taxes on stock gains, as well as returns on other kinds of investments (AKA the capital gains tax). Here’s an introduction into capital gains tax rates and how to calculate what you owe.
TL;DR
- Capital gains are earnings on assets like stocks, bonds, real estate and more.
- Short-term capital gains (returns on positions you held for less than a year) are taxed at the same rate as your income.
- Long-term capital gains (returns on positions you held for more than a year) are taxed at a lower rate.
- Dividends are taxable, even if you held the position.
- You can calculate your capital gains tax manually or with a calculator.
A word on stocks and taxes
Stocks are just one type of asset that the US government can (and does) tax its citizens on, but understanding the why and how behind stocks and taxes is a helpful benchmark for understanding taxes on all your investment earnings.
Stocks are taxed because, well, the government likes to tax our earnings. If it’s not in a tax-sheltered retirement account, it’s pretty much fair game.
Since you use your social security number to trade with a stock brokerage or perform other legitimate securities transactions, there’s no way to get around capital gains taxes. While investing in the stock market can be a wonderful way for you to make money today and earn capital for the future, your tax bill will reflect your investments.
What is the capital gains tax?
Capital gains tax = taxation on your capital gains. So what are capital gains?
Capital gains occur when you sell your securities for a higher rate than you initially paid for them or earned dividends. In the eyes of the government, this market return is likened to income. You can earn capital gains from a number of different assets, including:
- Stocks
- Bonds
- Precious metals & jewelry
- Real estate
There are two types of capital gains taxes: short term and long term.
- Investors pay short-term capital gains tax on securities held for less than one year. Short-term capital gains tax rates are in line with rates for other forms of taxable income.
- Investors pay long-term capital gains tax on securities held for a year or more. Long-term capital gains tax rates are lower than other types of taxable income. For example, folks in the 15%-or-lower tax bracket only have to pay 5% on their long-term capital gains. People in the 25%-or-higher tax bracket pay 15%. In 2019, the maximum long-term capital gains tax rate was 20%.
Back to those dividends. You may incur capital gains even if you didn’t sell a security. This is because certain positions earn dividends, which companies typically dole out on a quarterly basis.
The government taxes most dividends at the income tax rate. However, there are certain types of dividends called “qualified dividends” that the government taxes at just 015%.
So how do you get a qualified dividend? You invest in a US corporation or qualified corporation outside of the US. Just note that you have to hold the stock for at least 60 days to receive the qualified dividend perk on your taxes (which, if you’re investing in a dividend-paying company, you’re probably doing anyway to take advantage of those quarterly returns).
Dividends from retirement savings accounts like a 401k or IRA are not taxed.
How to calculate your capital gains taxes
As you can see, there are a lot of factors that go into determining capital gains tax rates. It’s very individualistic and depends on your market activity and asset holdings. I don’t have the same income or assets as my neighbor, so we don’t pay the same rate.
But how do you go about calculating your own taxes on capital gains? You can either:
- Do it manually
- Use a capital gains tax calculator
If you choose to calculate your capital gains tax manually, you need to:
- Look at all your assets and figure out which ones you’ve had for a year or more versus which ones you’ve had for less than a year.
- Figure out your tax bracket, which you can determine by figuring out your income. Here’s the latest rates based on income, according to the IRS.
- You’ll be able to calculate short-term assets at the same rate as your income tax. Long-term assets depend on your tax bracket and are lower than your income tax rate. Many people even earn a 0% rate if their income is in the lowest bracket, according to the IRS.
- Note any dividends you’ve earned during the year, even if you haven’t sold a dividend-paying position.
You may come to find that the manual route isn’t for you and that’s okay. It can be tedious, but besides that, you can calculate it inaccurately. This has the potential to leave people unprepared when it comes time to file taxes (seeing that you aren’t getting a sizable return is no fun; seeing that you owe more money to the government simply because of your investment success is even worse).
That’s where a capital gains tax calculator comes into play. Public offers a capital gains tax calculator for investors to use, whether or not they trade on our commission-free stock brokerage platform.
When to pay taxes on stock gains and other capital gains
Capital gains taxes are typically calculated quarterly, so you can pay them on each of the following:
- April 15 (for Q1)
- June 15 (for Q2)
- September 15 (for Q3)
- January 15 of the following year (for Q4)
If you want to pay quarterly, you must acquire a voucher for each quarter and mail it alongside a check or money order to the IRS prior to the due date. If you want to pay once a year, you may incur a small fee but you can increase your income tax withholding amount to avoid having to pay the IRS after receiving your tax return.
You can deduct capital losses to an extent
Not every securities transaction is in the green. If you sell your securities for a lower rate than you initially paid for them, you’re incurring capital losses. To offset your capital gains tax, you can deduct capital losses (short-term losses can offset short-term gains, and long-term losses can offset long-term gains). There is a limit on how much you can deduct, regardless of how long you held the position.
For 2020, the most you can deduct for stock losses is $3,000 per year. You can carry over any remaining losses to the following year. This means that if you had a bad investment year in 2020 but a profitable year in 2021, you can still deduct any leftover losses from the previous year.
Bottom line
There are more nuances on stocks and taxes than we’ve included here, but understanding the gist of capital gains tax will put you in a solid position as it comes time to file. Whether you’re a new investor or a veteran looking for a simpler way to calculate your capital gains tax, knowing what you owe, when you owe it and why you owe it in the first place is important.