New investors have a lot to learn, including how to select and open a brokerage account. But how investing and taxes work is something that new investors, and even some seasoned ones, frequently overlook.
It’s critical to understand which investments are taxable and which are not. It matters how you handle the tax and investment intersection because it can alter your profits. Here is an overview of the fundamentals to get you going.
Investing can be a great way to grow your wealth over time, but it’s important to understand the tax implications of your investments. Many new investors are unsure about how investing and taxes work, particularly when it comes to paying taxes on every stock trade. This guide will provide a comprehensive overview of investing and taxes, focusing on the key points that every beginner should know.
Understanding Capital Gains Taxes
The first thing to remember is that you only pay taxes on investments that increase in value if you sell them. In the United States, the government taxes your profits, not your holdings. This means that you won’t owe any taxes on your stocks until you sell them and realize a gain.
For example, if you buy a stock for $2,000 and sell it for $2,500, you have a $500 capital gain. This gain is subject to federal taxes. Capital gains taxes apply to most investment types, including bonds, mutual funds, ETFs, precious metals, cryptocurrencies, and collectibles. Even real estate sold at a profit can be considered a capital gain, though the rules are a bit more complicated.
The IRS splits capital gains into two main categories: long-term and short-term.
- Long-term capital gain: You sell and profit from an investment you’ve owned for longer than a year.
- Short-term capital gain: You sell and profit from an investment you’ve owned for a year or less.
For example, if you bought a stock on January 1, 2020, and sold it on January 2, 2021, you owned it for less than a year, so it’s taxed as a short-term gain. On the other hand, if you bought a stock on January 1, 2020, and sold it on January 1, 2021, you owned it for more than a year, and any resulting profit is taxed as a long-term capital gain.
As you’ll see in the next couple sections, long- and short-term capital gains are taxed differently.
Long-Term Capital Gains Tax Rates
Profit from selling an investment you’ve held for over a year is taxed according to the IRS’ long-term capital gains tax rates. Those rates are 0%, 15%, or 20%, depending on your total taxable income.
Here’s a quick look at the long-term capital gains tax rates for the 2023 tax year (the tax return you’ll file in 2024):
| Tax filing status | 0% rate | 15% rate | 20% rate |
|---|---|---|---|
| Single | Taxable income of up to $44,625 | $44,626 to $492,300 | Over $492,300 |
| Married filing jointly | Taxable income of up to $89,250 | $89,251 to $553,850 | Over $553,850 |
| Married filing separately | Taxable income of up to $44,625 | $44,626 to $276,900 | Over $276,900 |
| Head of household | Taxable income of up to $59,750 | $59,751 to $523,050 | Over $523,050 |
Data source: IRS
In addition to the rates listed in the table, higher-income taxpayers may also pay a 3.8% net investment income tax. This applies to any investment income, not just capital gains. Dividends, interest income, rental income from real estate, and passive business income counts toward your net investment income.
As with most things investing and taxes, the taxable limit depends on your filing status. If you are a married couple filing jointly with adjusted gross income of more than $250,000, your investment income above that threshold is taxed. If you’re married and file separately, the threshold drops to $125,000. For single, unmarried, or head-of-household filers, the threshold for the additional tax is an adjusted gross income of $200,000.
Only income above the threshold is subject to the net investment income tax. For example, if you and your spouse earn $200,000 from your jobs and $70,000 from your investments, only the $20,000 that makes your income exceed the threshold may be taxed at 3.8%.
Short-Term Capital Gains Tax Rates
Long-term capital gains receive favorable tax treatment, but short-term gains do not. If you earn a profit on an investment that you hold for a year or less, it is taxed using the same tax brackets as ordinary income.
This means short-term gains are typically taxed at a higher rate than long-term gains.
For reference, here are the 2023 U.S. tax brackets that apply to short-term capital gains:
| Tax Rate | Single Filers | Married Filing Jointly | Heads of Households |
|---|---|---|---|
| 10% | $0 to $11,000 | $0 to $22,000 | $0 to $15,700 |
| 12% | $11,001 to $44,725 | $22,001 to $89,450 | $15,701 to $59,850 |
| 22% | $44,726 to $95,375 | $89,451 to $190,750 | $59,851 to $95,350 |
| 24% | $95,376 to $182,100 | $190,751 to $364,200 | $95,351 to $182,100 |
| 32% | $182,101 to $231,250 | $364,201 to $462,500 | $182,101 to $231,250 |
| 35% | $231,251 to $578,125 | $462,501 to $693,750 | $231,251 to $578,100 |
| 37% | Over $578,125 | Over $693,750 | Over $578,100 |
Data source: IRS
What if Your Capital Gains Are Negative?
Sometimes, you may not have any gains when you sell investments. In some cases, you may even find yourself with capital losses.
You can use capital losses to reduce your capital gains. In other words, if you sell a stock at a $5,000 profit but sell another stock at a $1,000 loss, your taxable capital gain for the year is $4,000.
You must use long-term capital losses to offset long-term gains before applying them toward short-term capital gains. Similarly, you must use short-term losses to reduce short-term before long-term gains.
If your capital losses are greater than your capital gains in a given year, you can use them to offset your other taxable income. This deduction is capped at $3,000 per tax year (or $1,500 if married and filing separately). However, if your net capital losses exceed the capped amount, you can carry them over to subsequent years.
Dividend Taxes: When You Receive Shareholder Profits
Capital gains and losses aren’t the only important part of investing and taxes. Dividends (earnings distributed by companies to shareholders) are also taxed, at a rate depending on the classification.
Just as with capital gains taxes, dividends have two basic classifications for tax purposes: qualified dividends and ordinary dividends. Qualified dividends are taxed at the long-term capital gains rates. Ordinary dividends are taxed like ordinary income.
To be considered a qualified dividend, two basic requirements must be met:
- The company that paid the dividend must be a U.S. corporation or a qualified foreign corporation, which generally means the stock is traded on U.S. exchanges.
- You must have owned the stock for 60 days during the 121-day period starting 60 days before the stock’s ex-dividend date and ending 60 days afterward. (Preferred stock has a stricter ownership requirement of 90 days out of the 181-day window beginning 90 days before the ex-dividend date.)
Some dividends are never considered “qualified.” These include dividends from tax-exempt organizations, capital gains distributions, dividends paid on bank deposits (for example, credit unions often pay dividends on deposit accounts), and dividends paid by a company on stock held in an employee stock ownership plan (ESOP).
In addition, dividends paid by pass-through entities, such as real estate investment trusts
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New investors have a lot to learn, including how to select and open a brokerage account. But how investing and taxes work is something that new investors, and even some seasoned ones, frequently overlook.
It’s critical to understand which investments are taxable and which are not. It matters how you handle the tax and investment intersection because it can alter your profits. Here is an overview of the fundamentals to get you going.
What if your capital gains are negative?
Sometimes, selling investments might not result in any profits for you. There are instances where you might even experience capital losses.
You can use capital losses to reduce your capital gains. Put differently, your taxable capital gain for the year is $4,000 if you sell a stock at a $5,000 profit and another stock at a $1,000 loss.
Before applying long-term capital losses to short-term capital gains, you must use them to offset long-term capital gains. In the same way, you have to use short-term losses to offset short-term gains prior to long-term gains.
You can deduct other taxable income from your capital losses if they exceed your capital gains in a particular year. The maximum deduction for this tax year is $3,000 (or $1,500 if you’re married and filing separately). On the other hand, you can carry over your net capital losses to later years if they exceed the capped amount.
Taxes on Stocks Explained for Beginners that Know NOTHING About Taxes
FAQ
Do day traders pay tax on every trade?
Do I have to report stocks on taxes if I made less than $1000?
Do you have to claim all stocks on taxes?
Do you pay taxes on stock trades?
When you sell stocks, your broker issues IRS Form 1099-B, which summarizes your annual transactions. Obviously, you don’t pay taxes on stock losses, but you do have to report all stock transactions, both losses and gains, on IRS Form 8949. Do you have to list every stock trade on your tax return?
Do you pay tax if you sell a stock?
The most well known is the tax liability incurred when you sell a stock that has appreciated in value since you purchased it. The difference in value is referred to as a capital gain. When you have capital gains, you must pay taxes on those earnings. Capital gains even have their own special tax levels and rules.
Do you pay tax on dividends if you own a stock?
In addition, you must own the stock for a specific period of time. They are taxed at 0%, 15%, and 20%. 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.
Do you pay taxes if a stock goes up?
No. Even if the value of your stocks goes up, you won’t pay taxes until you sell the stock. Once you sell a stock that’s gone up in value and you make a profit, you’ll have to pay the capital gains tax. Note that you will, however, pay taxes on dividends whenever you receive them.