How are stocks taxed?

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Understanding the way stocks are taxed is very important, as it affects the value of your investment and is one of the major factors to be taken into account in making buy/sell decisions.

 

Profit from the Sale of Stocks

While your broker or financial adviser will probably explain to you the tax implications for your stock portfolio, understanding the process is essential for you both for making decisions and filling the paperwork. Before moving to the main discussion, one important thing to remember is to “keep the receipt for the purchases and sales of the stocks throughout the year” to be able to easily fill in the tax returns.

With the exception of owning stocks in tax-sheltered retirement accounts such as IRAs or 401(k)s, stock owners have to pay taxes when they sell their securities. 2 cases are possible here – your holdings have increased in value meaning you have a capital gain or they have decreased in value, which means you have a capital loss.

Capital Gains Tax

If the stock price has increased during your holding period, you have to pay a capital gains tax on the profit, or, in other words, on the difference of purchase and selling price including any purchase and selling commissions.

There is a distinction between short-term and long-term gains. If you sell the securities after holding them for at least a year, your profit is taxed at a capital gains rate. This rate is dependent on your tax bracket, and can fluctuate between 0% and 20%, but still it is lower than the regular income tax rates.

If the stocks you sell were being held less than a year, the profits are treated as short-term capital gains and taxed at the same rate as your regular income. So the amount of taxes paid will be directly dependent on which tax bracket you are.

Capital Loss Tax

If the amount between the sale price and purchase price is negative, a capital loss is reported. In this case a specific guidelines have to be followed relating to taxes on this loss.

If the loss on this sale exceeds any gains that you’ve had, a yearly amount up to $3,000 is allowed to be deducted on your tax return. Any remainder is carried forward to the next year.

Note that in this case it would have been possible to sell your losing stocks in order to offset the gain from other stocks and immediately buy them back. However, there is a restriction, preventing investors from such fraudulent activities. “The Wash Rule” doesn’t allow investors to claim capital loss if the losing stock is bought back within 30 days.

Dividends

Dividends are taxed at a capital gains rate if they are considered qualified. Those are dividends that are being paid from domestic corporations and qualified foreign corporations. In contrast, non-qualified dividends, such as those received as an employee stock options, paid by REITs or paid on savings accounts, are taxed at a regular income tax rate.

To summarize, it is very important to understand how stocks or any other securities that you own or are looking to buy, are taxed. While you will probably get some advice from your broker, learning about different tax rates and how they apply to you is a must when investing in securities.

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