It doesn’t come as a surprise to most people that they have to pay taxes on the income that they earn working their job. Some people are surprised, however, when they learn that taxes must be paid when they earn money investing in the stock market.
Main Types of Taxes Paid on Stocks
There are two main types of taxes paid on stock earnings: capital gains taxes and taxes on dividends. Capital gains taxes are typically the most common type of tax paid on stock earnings. They are assessed on profits earned when stocks are sold.
Taxes on dividends, meanwhile, must be paid if a stock pays out dividends to investors. Ordinary dividends are taxed at ordinary income tax rates, while qualified dividends that meet certain criteria are taxed at lower capital gains tax rates. Note that dividends earned in a qualified retirement account such as a 401k or IRA are not taxable.
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Capital Gains Taxes
Capital gains taxes are due when stocks are sold and assessed on the appreciation in the value of the stock since it was first purchased — or in other words, your profit on the sale of the stock. If you sell a stock at a loss, you’ll owe no tax upon the sale because there was no profit.
Capital gains tax rates are generally lower than ordinary tax rates.
Short-Term Capital Gains Tax
If you hold a stock for less than one year before selling it, your gain will be taxed at your ordinary income tax rate. For exceptions to this rule, such as property acquired by gift, property acquired from someone who has died, or patent property, check out the IRS rules.
Long-Term Capital Gains Tax
If you hold a stock for one year or longer, your gain will be taxed at the long-term capital gains tax rate.
Your long-term capital gains tax rate is based on your adjusted gross income, or AGI.
For tax year 2021, some or all net capital gain may be taxed at 0% if your taxable income falls under the following thresholds. For tax year 2021, your tax rate is 15% for long-term capital gains and dividends if your AGI falls within the following ranges:
$40,401 to $445,850 for single filers
$80,801 to $501,600 for married couples filing jointly or qualifying widow(er)s
$54,101 to $473,750 for heads of household
$40,401 to $250,800 for married couples filing separately
If your AGI exceeds these limits, your capital gains tax rate is 20%.
How Are Capital Gains Taxes Calculated?
When you sell a stock, you don’t pay capital gains tax on the entire amount of the sale — you only pay it on your profit from the sale. To calculate how much tax you owe, you must subtract how much you paid for the stock, along with any commissions and reinvested dividends, from how much you sold it for. This is known as your cost basis.
For example, let’s say you bought a stock five years ago for $2,000 (including commissions) and reinvested dividends annually totaling $400. Your cost basis would be $2,400. Now let’s say you sell the stock this year for $4,000. You would be taxed on $1,600, which is your net profit on the sale of the stock.
If you’re in the 15% capital gains tax bracket, your total tax on the sale would be $240.
How to Lower Your Taxes on Stocks
There are a few ways to lower the capital gains taxes you pay on profits from the sale of stock. One strategy is to deduct any management fees or commissions you paid to stockbrokers. You’ll report these fees on Schedule A of your tax return.
Another idea is to offset capital gains with capital losses from other investments. Sometimes referred to as tax-loss harvesting, this strategy involves selling underperforming investments and booking a loss. You can use these losses to offset up to $3,000 each year in taxable investment gains and ordinary income if you don’t have this much in gains. Unused investment losses each year can be carried forward to offset capital gains and ordinary income in future years.
Read More: Guide to Tax-Loss Harvesting
For example, let’s say you realized a taxable profit on a stock sale this year of $5,000. However, you own a stock that has fallen in value by $2,000 and you don’t expect it to recover anytime soon. You could sell this stock, book the $2,000 loss and reduce the taxable gain on the other stock to just $3,000.Note that you can buy back the stock you sold at a loss if you wait at least 30 days to do so. If you buy it back sooner than within 30 days, the IRS will disallow using the loss to offset the capital gain; this is known as the wash-sale rule.
Next Steps for You
Taxation of gains on stock sales can be complicated. Therefore, be sure to talk to your tax advisor and personal financial planner for guidance in your specific situation.
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This way, when tax season rolls around, you’ll know exactly where you stand financially and can make moves on optimizing your investments.
Personal Capital compensates Brian E. Leyde (“Author”) for providing the content contained in this blog post. The information and content provided herein is general in nature and is for informational purposes only. Individuals should contact their own professional tax advisors or other professionals to help answer questions about specific situations or needs prior to taking action based on this information. Tax laws and authorities are subject to change, either prospectively or retroactively, and any subsequent change could have a material impact on your situation. The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money. Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.