As investing in the stock market has become more and more popular, many people are starting to ask about how this income is taxed. Unlike wages, investors in the stock market are completely on their own to determine their tax burden. While many investors rely on accounting firms to take care of the specifics, it's important for anyone who is in the stock market to understand the basics of how they are taxed so that they can make smart investment decisions.
In the United States, taxes are only paid on the profit that is made on stocks. Take, for example, a person who invests $50,000 into the stock market. Five years later that person has made $80,000, but only chooses to sell $10,000 of the stock leaving $70,000 in the market. The $30,000 that person has made is their profit, of which $10,000 are realized capital gains and $20,000 is unrealized capital gains. The $10,000 they took out can be spent on anything, and the investor must pay taxes on this amount. The remaining money that is still in the market can continue to grow with the investor not paying taxes on it, but he or she will need to pay taxes on their earnings when the money is removed from the market.
It does not matter how long the money has been in the market for; investors have to pay taxes on their earnings. There are, however, several differences in the amount of taxes that need to be paid. In general, capital gains are taxed at different rates for people who have their money invested for less than one year versus over one year.
Short-term capital gains are taxed as ordinary wage income. People who dabble in day trading are most likely to fall into this category. Long-term capital gains, however, are taxed at a rate between zero and 20%, based on total income.
For this reason, it's important to consider how long an investment has been in place before deciding to sell. For example, a person who makes ordinary wages of $200,000 per year and capital gains of $10,000 would most likely pay no taxes at all if the investment was sold after the one year mark, but he or she would lose about 34% of the investment to taxes if it was sold before the one year mark.
Dividend income is considered to be profit from the investment, and all of it is taxed as capital gains. That means that investors who take distributions of The exception to this is for investors who automatically reinvest their dividends back into the stock market. This method, commonly known as DRIP, will prevent the investor from having to pay taxes on the dividends until he or she chooses to sell the stock and take the money out of the market.
If you are pulling your dividends out of the market, it's important to know if the dividends are qualified or non-qualified. In general, qualified dividends are dividends paid on assets that the investor has held for 61 days or more. Non-qualifying dividends are for assets held for less than that. Qualified dividends are taxed at normal capital gains rates, while nonqualified dividends are taxed at normal wage rates.
While it is possible to write a book on tax planning with stocks (and many people have), if you're just starting out, the important thing to consider is how to reduce your tax burden as much as possible. For new investors, consider how you will use your money. If you are investing for long-term goals such as retirement or a child's college education, then it makes sense to research and utilize investment accounts such as IRAs and 529 plans to shield your investment from taxes.
If you are just looking to make some extra money, however, then it's worth the time to track the start date of each investment and calculate your potential tax burden before pulling your money out of the market. In general, tax burdens are low for people who leave their money in the market for extended periods of time, but there are exceptions to this rule.
For example, an investor who is able to reduce his or her wage income to zero for a year may choose to pull out short-term investments during that period in order to reduce the tax burden that he or she would otherwise pay. Similarly, investors can time pulling money out of the markets to coincide with major life events such as having a baby or buying a home that can have major tax implications of their own.
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It's important to keep track of your stock purchases and sales so that you can accurately report your capital gains on your tax return. You will need to report the date of your purchases, the date of your sales, and the proceeds from the sales. You may also be able to claim losses on your tax return if you sold stocks at a loss. Keep in mind if you have owned the stock for less than one year and have sold it for profit, you will have to pay taxes at the regular income tax rate. However, if you owned the stock for over one year, the capital gains rate will apply, which varies based on annual income.
For those investing in stocks, it's helpful to have a tax professional by your side. Lowering your tax burden often isn't easy to do on your own, and that's where we can help. The team at the MB Group has years of experience helping both individuals and businesses alike with their tax and accounting needs. Contact the MB Group today to get started.
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