Investing in the stock market can be an effective wealth-building strategy. When you choose to sell your shares, however, you may face capital gains tax on the profits of your sale.
Learn about the taxes you face on stocks and dividends so you can minimize your tax exposure and effectively build your investment portfolio.
Capital Gains Tax On Stock
If you profit from selling a stock, you must pay capital gains tax on the profit. Depending on how long you owned the stock before selling, you either pay a short-term or long-term capital gains tax.
If you make a profit selling an asset you held for one year or less, you must pay short-term capital gains tax on the profit. The IRS taxes short-term capital gains at the same rate as your federal income bracket.
The IRS adjusts these tax brackets every year to compensate for inflation. In 2022, there are seven federal income tax brackets, with tax rates ranging from 10% to 37%.
For example, if you make $50,000 a year as a single filer, you fall into the 22% tax bracket. If you sold stock for a profit that tax year but only held the stock for 6 months before selling, you must pay a 22% short-term capital gains tax on the profit of the sale.
If you make a profit by selling an asset you have held for more than one year, your long-term capital gains tax rate is between 0% and 20%, typically 15%. Your rate depends on your filing status and taxable income.
To minimize capital gains, many owners choose to hold their stock for at least a year to qualify for the lower long-term capital gains tax rate.
Taxes On Dividends
Some companies issue dividends to their shareholders in the form of stocks or cash payments. These dividends are also usually taxable. For tax purposes, the IRS considers dividends to be either qualified or nonqualified (ordinary).
Nonqualified dividends are the more common form of distribution from a corporation. These dividends are paid out as earnings and do not count as capital gains. Your nonqualified dividends will be shown in box 1a of Form 1099-DIV you receive from the corporation.
Qualified dividends, on the other hand, are taxed at a rate of 0%, 15%, or 20%, based on your filing status and taxable income. Your qualified dividends will be shown in box 1b of Form 1099-DIV you receive from the corporation.
IRS Publication 550, Investment Income and Expenses, specifies what investment income is taxable, what is deductible, and where to include these items on your return.
Pay Lower Taxes on Your Stocks
To minimize your tax exposure, consider holding on to your stocks for over a year. If you hold a stock or other assets for over a year, you qualify for the lower long-term capital gains tax rate.
Stock market losses are called capital losses or capital gains losses. You can use realized capital losses from stock to offset your capital gains, thereby removing income from your tax return and reducing your tax bill.
Publication 550 also outlines specific instances where you can defer capital gains on the sale of stocks. For example, if you hold qualified stocks for at least three years and sell them to an eligible Employee Stock Ownership Plan (ESOP), you may be able to postpone paying capital gains if you use the funds to buy a qualified replacement property.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
