Just as you owe taxes on money that you earn by working, you may also owe taxes on money that you earn through investments.
That’s important for investors to understand, so that they can plan for the tax implications of their investment strategy. Understanding how your investments could impact your taxes better prepare you for tax season and allow you to make more informed investment decisions.
Some investments may not look as appealing after you’ve factored in the potential impact of taxes, and taxes could impact both your returns and your payback period. That’s why it’s important to know the answer to the question: How are stocks taxed?
Before we get into it, we just want to say up front that we don’t provide tax advice. We can outline a few tax guidelines that you should pay attention to but, to fully understand the implications, you’ll want to consult a tax professional.
When Do You Pay Taxes on Stocks?
There are several scenarios in which you may owe taxes related to the stocks you hold in an investment account. 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.
You owe capital gains taxes only on your investments’ growth, based on the increase in value from when you bought them until when you sell them. That’s important to consider, whether you’re purchasing IPO stocks or buying blue chip established companies.
There are two types of capital gains tax:
Short-term Capital Gains
Short-term capital gains tax applies when you sell an asset that you owned for a year or less that gained in value. These gains would be taxed at the same rate as your typical tax bracket (here they are for the 2021-2022 tax year), so they’re important for day traders to consider.
Long-term Capital Gains
Long-term capital gains tax applies when you sell an asset that gained in value after holding it for more than a year. Depending on your taxable income and tax filing status, you’d be taxed at one of these three rates: 0%, 15%, or 20%. Overall, long-term capital gains tax rates are typically lower than those on short-term capital gains.
If you sell a stock for less than you purchased it, the difference is called a capital loss. You can deduct your capital losses from your capital gains each year, and offset the amount in taxes you owe on your capital gains.
You can also apply up to $3,000 in investment losses to offset regular income taxes.
Taxes on Investment Income
You may have taxes related to your stock investments even when you don’t sell, if the investments generate income.
You may receive periodic dividends from some of your stocks when the company you’ve invested in earns a profit. If the dividends you earn add up to a large amount, you may be required to pay taxes on those earnings. Each year, you will receive a 1099-DIV tax form for each stock or investment from which you received dividends. These forms will help you determine how much in taxes you owe.
There are two broad categories of dividends: qualified or nonqualified/ordinary. The IRS taxes nonqualified dividends at your regular income tax bracket. The rate on qualified dividends may be 0%, 15%, or 20%, depending on your filing status and taxable income. This rate is usually less than the one for nonqualified dividends, though those with a higher income typically pay a higher tax rate on dividends.
This money can come from brokerage account interest or from bond/mutual fund interest, as two examples, and it is taxed at your ordinary income level. Municipal bonds are an exception because they’re exempt from federal taxes and, if issued from your state, may be exempt from state taxes, as well.
Net Investment Income Tax (NIIT)
Also called the Medicare tax, this is a flat rate investment income tax of 3.8% for taxpayers whose adjusted gross income exceeds $200,000 for single filers or $250,000 for filers filing jointly. Taxpayers who qualify may owe interest on the following types of investment income, among others: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, and income from businesses involved in trading of financial instruments or commodities.
Recommended: Investment Tax Rules Every Investor Should Know
When Do I Not Have to Pay Taxes on Stocks?
Again, this should first and foremost be a discussion you have with your tax professional. But there are a few situations you should know about where you often don’t pay taxes when selling a stock. For example, if you are investing through a tax-deferred retirement investment account like an IRA or a 401(k), you won’t have to pay taxes on any gains when you buy and sell stocks inside the account. However, if you were to sell stock in one of these accounts and then withdraw it, you could owe taxes on the withdrawal.
How to Pay Lower Taxes on Stocks
If the answer to “Do you have to pay taxes on stocks?” is “yes” for your personal financial situation, then the question becomes how to pay a lower amount of taxes. Strategies can include:
• Holding on to stocks long enough for dividends to become qualified and for any capital gains tax to be in the long-term category because they are typically taxed at a lower rate
• Offsetting your capital gains with capital losses
• Putting your investments into retirement accounts or other tax-advantaged accounts
• Avoiding the temptation to make early withdrawals from your 401(k) or other retirement accounts.
The tax implications of your investments will vary depending on the types of investments in your portfolio and the accounts you use, among other factors. That’s why it may be worthwhile to work with an experienced accountant and a financial advisor who can help you understand and manage the complexities of different tax scenarios.
Many investment banks offer investing advice and guidance tailored to your needs. Some even offer advanced online tools to help you balance your investments and stay on target to reach your goals. Research and compare accounts to find an investment bank that meets your needs.
The SoFi Invest® brokerage platform offers convenient, easy-to-access investing options when you buy stocks online that pair the best of automated investing with custom advice from financial professionals. The platform allows you to get started investing by easily purchasing stocks, exchange-traded funds, cryptocurrencies, and buy IPO stock.
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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.