If you’re reading this and have already made the decision to become an investor, you deserve congratulations. Long-term investing is a critical tool for building wealth.
But becoming an effective investor requires more than just a commitment to buy stocks; it also means educating yourself about the various ways investing money impacts your overall finances, including your taxes.
An important way to start your investor education is to become fluent in the terms that are used to describe income earned through your investing and, more important, the very real implications those investments can have on your yearly income tax bill.
How You Make Money From Investments
Most of us already know how to handle the taxes we earn from our wages and salaries, also known as ordinary income. Understanding the tax implications of a portfolio made up of stocks, bonds, mutual funds and other investments is similar, albeit with plenty of nuance.
Newspapers and websites exhaustively document the ups and downs of the stock market. Those gyrations reflect the profits and losses of stocks, bonds and other investments. For investors, the most basic objective is to sell their investments at a higher price than when they first purchased them. It’s where the phrase “buy low, sell high” comes from.
Those who do this successfully have earned capital gains. “Capital gains are the profits you make from the sale of a capital asset, like shares in stocks or a business,” says George Birrell, a certified public accountant and founder of the website TaxHub. Obviously, not all investments are sold for a profit. When an investor sells a stock, bond or other investment for a price lower than when they bought it, that is called a capital loss.
Another common investment term is dividend. Think of a dividend as a bonus payment from a company whose stock you own. Companies issue dividend payments to their investors based on the profits they earn. How much of a bonus you receive depends on how many shares you own. For example, if you own 100 shares of a company and it declares a dividend of 25 cents per share, you would receive $25. That’s good news, but it’s also investment income that’s taxable.
Tax Implications of Gains, Losses and Dividends
Before delving into some of the tax minutiae of different investments, it’s helpful to remember how your income tax is calculated each year. At the most basic level, there are currently seven income tax brackets, each of which determines how much tax you have to pay depending on how much income you earn. For example, a single person earning between $40,126 and $85,525 pays up to 22% of their taxable income in federal taxes while someone making between $207,351 and $518,400 pays up to 35%.
Put another way, calculating tax can be complicated because the rates differ depending on how much you earn. Muddying that calculation even more is when you have to incorporate capital gains, losses and dividends into the mix.
● Capital Gains: Determining the tax rates that apply to those investments is a function of how long you have owned them. “For federal tax, the difference between short-term and long-term gains is whether the asset has been held for over one year continuously. The federal long-term capital gains tax is significantly lower than the short-term rate for most investors,” says Asher Rogovy, chief investment officer at Magnifina LLC, a New York-based investment advisory.
For example, long-term capital gains are taxed at no more than 15%, while short-term capital gains are taxed at the rate you pay on your tax return—which can be significantly higher than 15%, depending on how much you earn. “Because the long-term rate is lower, investors who have held a profit for 11 months may consider waiting another month before realizing the profit,” Rogovy says.
● Capital Losses: Since not all investments earn a profit, it’s also possible to reduce your overall tax liability by writing off any capital losses you may have over the course of a year. That means that if some or all of your stocks lose money, you may be able to lower your overall yearly income tax bill.
● Dividends: These bonus payments come in two categories: qualified and nonqualified. Nonqualified dividends are usually referred to as “ordinary dividends” and are taxed at the same rate as your regular income. Qualified dividends, which meet specific IRS guidelines, are also taxable, though usually at a lower rate compared to nonqualified dividends. According to the IRS guidelines for dividends, the yearly tax forms you receive (see below) will indicate whether a specific dividend you received is one or the other.
Tax-Advantaged Investments
Many of us have our investments in an IRA or a 401(k) plan, both of which are tax-advantaged accounts. This doesn’t mean you aren’t on the hook to pay taxes. Rather, tax-advantaged accounts allow investors to deduct their contributions (up to a certain amount, depending on your filing status) in the tax year when they’re made. But when you withdraw money from those investments in retirement, you’ll have to pay taxes at a rate determined by your income at the time. Roth IRAs are an exception. While you can’t deduct contributions, withdrawals are tax-free.
Look for Tax Forms
Whether you’re an investor or not, preparing and paying your taxes is a paperwork heavy exercise. If you are a new investor, you’ll need to keep an eye out for forms beyond just the W-2s and 1099s that document your income. One is the 1099-DIV, which is sent by any company that paid you a dividend the previous year. Those forms are issued by January 31 of the year you actually pay your taxes.
Arriving at the same time are 1099-B forms, which document all of your stock transactions. This includes the name of the company whose stock you bought or sold, the transaction date, whether there was a loss or gain and whether it was a short- or long-term capital gain or loss. “It’s critical that this information is turned in to your tax professional so your stock trading is properly recorded on your tax return,” says Timalyn Bowens, founder of Louisville, KY-based Bowens Tax & Bookkeeping Solutions LLC.
A former editor at Los Angeles magazine, Chris Warren has had work appear in publications ranging from Institutional Investor and Forbes to National Geographic Traveler, Oxford American and Greentech Media.
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