How are stocks taxed?
If you’re new to investing, you may also be new to understanding taxes on investments. When thinking about how stocks are taxed, capital gains come to the minds of many. But taxation of stock can also include dividends. We’ll cover both concepts so you know what to expect as you invest.
Taxes on stocks: Understanding capital gains vs. dividends
There’s a wide array of options for stock investors, each providing different advantages. Some stocks are all about growth and ideally, you benefit from share price appreciation (meaning the share price goes up). Other stock types pay dividends on top of having the potential for growth.
For these reasons, taxes on stocks can cover several scenarios.
- Capital gains – long and short term
- Ordinary dividends
- Qualified dividends
Capital gains tax
Buying low and selling high is traditional advice for investing. It’s also the recipe for generating a capital gain. Suppose you earn a $10 profit on an investment like mutual funds, bonds, real property, or certain stocks after selling it for $30 (vs. its purchase price of $20). In that case, you’ll likely incur capital gains tax. What’s more, the amount of time you hold the capital asset affects your capital gains tax rate.
Learn more about the difference between long- and short-term capital gains tax.
Here’s a bit more clarity:
For tax purposes, when you sell an investment for more than you bought it, you realize a capital gain. This gain is taxable, and the tax rate depends on the length of time you hold the stock before selling it.
- Short-term capital gain: A short-term capital gain occurs when you sell assets you owned for one year or less. Short-term capital gains are taxed using the following ordinary income tax rates, depending on your taxable income:
- Long-term capital gain: If you owned the stock for more than a year before selling, the gain is long term. Long-term capital gains are taxed at the following rates, depending on your taxable income:
If you sell a stock for less than its original purchase price, your investment incurs a capital loss. Find out how you can offset your capital gains with losses.
Tax tips for capital gains
You may have noticed that the tax rates for long-term capital gains are more favorable than those of short-term capital gains. Essentially, this rule can give you an incentive to invest in a stock with more of a buy and hold strategy versus making more frequent trades.
While taxes shouldn’t be the primary driver of your investment decisions, it’s something to keep in mind. For example, if you’re considering selling a stock you’ve owned for 11 months, you might wait the extra month if it makes sense for your overall investing goals. The few extra weeks could allow you to pay the lower long-term capital gain rates if you’ve made a profit.
Dividends are typically paid out quarterly or annually — and are often used as a way for companies to reward shareholders for investing in their business.
Dividends are considered income, and as such, they’re taxed by the IRS. But, like capital gains, not all dividends and dividend income are taxed alike, and you can benefit from holding stocks longer.
The categories of dividends — qualified and nonqualified — depend on how long you’ve held the stock, your filing status, and taxable income.
- Nonqualified (or ordinary) dividends include certain dividends paid by a foreign company, distributions from some U.S. business entities, like real estate investment trusts and master limited partnerships, dividends paid on employee stock options, special one-time dividends, common stock dividends. They are taxed at ordinary income rates using the standard income tax bracket.
- Qualified dividends are dividends that are paid by a U.S. company or a foreign company that trades in the U.S. or has a tax treaty with the U.S. In addition, you must own the stock for a specific period of time. They are taxed at 0%, 15%, and 20%.
Tax tips for dividends
There are a few tax tips if you own stocks that pay dividends. For instance, when and how you hold the stock can dramatically change the tax treatment. For instance, you might pay less tax on your dividends by holding the shares long enough for the dividends to count as qualified.
Net investment income tax
High-income earners will want to be mindful of the net investment income tax that applies to certain investment income. It’s a 3.8% tax that applies to your net investment income or modified adjusted gross income (MAGI) above:
- $125,000 for those with the Married Filing Separately status
- $200,000 for those with the Single or Head of Household status
- $250,000 for those with the Married Filing Jointly or Qualifying Surviving Spouse status
You should use Form 8960 if you have to pay net investment income tax.
Get help with investment income taxes
It’s important to note that tax laws are subject to change and can be complex. You can always lean on H&R Block for help navigating the nuances of taxes on investments.
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