Taxes on stocks basics

Before you sell your stocks, make sure you know what you’ll pay.  One of the best thing about tax breaks in investing is that no matter how much your stocks worth, you don’t have to pay taxes until you actually sell your shares. However, once you do, you’ll owe capital gains tax.  This is why you should usually hold stocks within tax sheltered retirement accounts like IRA and 401k, even mutual funds are subject to tax.

Under current tax law, you only pay tax on the the profit you made from selling your shares.  For example, if you bought it for 10 dollars and sold it for 20, that 10 dollars will be taxable. If you happen to lose money instead of gaining, then not only do you not have to pay tax, but you can use it as a deduction, and sometimes against other types of income.  For example, you sold stock X and made 20 dollar profit and sold stock Y and made -30 dollar profit.  At this point, you don’t need to pay any tax since you didn’t make any money.  You can also use the -10 dollar loss for your next tax return.

I talked about this on my last post, but the current tax laws separates long-term capital gains and short-term capital gains. If you’ve owned a stock for a year or less, then any gain on its sale is treated as short-term capital gain. Short term gains are taxed at the same rate as what you would pay on any other source of income, and so the amount of tax due will vary depending on what tax bracket you’re in.

In other hand, if you’ve held the stock for longer than a year, then you qualify for long-term capital gains treatment. Tax rates for long-term gains are lower than for short-term gains, with those in the 10% and 15% tax brackets paying 0% in long-term capital gains tax, those in the 25% to 35% tax brackets paying 15%, and those in the top 39.6% tax bracket paying 20%.  If you get paid dividends, those will be considered regular income and will be taxed at a short term gain rate.

Ordinary dividends earned on your stock holdings are taxed at regular income tax rates, not at capital gains rates. However, “qualified dividends” are taxed at a very advantageous capital gains rate of 0% to a maximum of 15%. For dividends to be classified as “qualified” they must be paid by a U.S. corporation or a qualified foreign corporation and the holding period of the stock must be more than 60 days.

Sometimes the tax for stocks can get a little difficult.  For instance, if you inherit stock, its tax cost is adjusted to reflect its value on the date of death of the person who left it to you. Also, some companies make payments to shareholders that are treated as return of capital, and that adjusts your tax cost downward for purposes of calculating later gain.

Other complicated issue you should keep in mind is that there are rules for balancing out gains and losses.  First, you add up gains and losses within the short-term and long-term categories across all your stock sales in a given year.  Then, a net loss in one category offsets net gains in the other category.  For example, if you lost money in your dividend portion of the portfolio, you can use that loss to offset the profit you made on the growth portion of the stock, so you can pay less on tax.  If you made too much loss, the remaining losses can be deducted up to $3,000 against other income, with an excess carried forward to future years.  One of the big limitations in stock investing is the amount of losses you are allowed to deduct on your tax return. If you sell stocks at a loss, you may deduct only $3,000 per year

Lastly, remember the wash rule.  Many investors benefit from selling a stock in a losing position to offset a gain, then turn around and buy the stock right back.  However, the IRS will not allow an investor to claim a capital loss if you sell a stock and buy it back within 30 days. The “wash rule” prevents you from claiming a loss on a sale of stock if you buy replacement stock within the 30 days before or after the sale and you will lose the offset.

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