The Tax Treatment of Different Investments

The following discussion tells you what you need to know about the tax implications you face when you start investing in stocks. It’s good to know in advance the basics on ordinary income, capital gains, and capital losses because they may affect your investing strategy and your long-term wealth-building plans.

Understanding ordinary income and capital gains

Profit you make from your stock investments can be taxed in one of two ways, depending on the type of profit:

• Ordinary income: Your profit can be taxed at the same rate as wages or interest — at your full, regular tax rate. If your tax bracket is 28 percent, for example, that’s the rate at which your ordinary income investment profit is taxed. Two types of investment profits get taxed as ordinary income (check out IRS Publication 550, “Investment Income and Expenses,” for more information):
  • Dividends: When you receive dividends (either in cash or stock), they’re taxed as ordinary income. This is true even if those dividends are in a dividend reinvestment plan . If, however, the dividends occur in a tax-sheltered plan, such as an IRA or 401(k) plan, then they’re exempt from taxes for as long as they’re in the plan.

Keep in mind that qualified dividends are taxed at a lower rate than nonqualified dividends. A qualified dividend is a dividend that receives preferential tax treatment versus other types of dividends, such as unqualified dividends or interest. Typically a dividend is qualified if it is issued by a U.S. corporation (or a foreign corporation listed on U.S. stock exchanges) and the stock is held longer than 60 days. An example of an ordinary dividend that is not qualified is a dividend paid out by a money market fund or a bond-related exchange-traded fund (because the dividend is technically interest).

• • Short-term capital gains: If you sell stock for a gain and you’ve owned the stock for one year or less, the gain is considered ordinary income. To calculate the time, you use the trade date (or date of execution). This is the date on which you executed the order, not the settlement date. However, if these gains occur in a tax-sheltered plan, such as a 401(k) or an IRA, no tax is triggered.
• Long-term capital gains: These are usually much better for you than ordinary income or short-term gains as far as taxes are concerned. The tax laws reward patient investors. After you’ve held the stock for at least a year and a day (what a difference a day makes!), your tax rate on that gain may be lower. (See the next section for more specifics on potential savings.) Get more information on capital gains in IRS Publication 550. Fortunately, you can time stock sales, so always consider pushing back the sale date (if possible) to take advantage of the lesser capital gains tax.

You can control how you manage the tax burden from your investment profits. Gains are taxable only if a sale actually takes place (in other words, only if the gain is “realized”). If your stock in GazillionBucks, Inc., goes from $5 per share to $87, that $82 appreciation isn’t subject to taxation unless you actually sell the stock. Until you sell, that gain is “unrealized.” Time your stock sales carefully and hold onto stocks for at least a year and a day (to make the gains long-term) to minimize the amount of taxes you have to pay on them.

When you buy stock, record the date of purchase and the cost basis (the purchase price of the stock plus any ancillary charges, such as commissions). This information is very important come tax time should you decide to sell your stock. The date of purchase (also known as the date of execution) helps establish the holding period (how long you own the stocks) that determines whether your gains are considered short-term or long-term.

Say you buy 100 shares of GazillionBucks, Inc., at $5 and pay a commission of $8. Your cost basis is $508 (100 shares times $5 plus $8 commission). If you sell the stock at $87 per share and pay a $12 commission, the total sale amount is $8,688 (100 shares times $87 minus $12 commission). If this sale occurs less than a year after the purchase, it’s a short-term gain. In the 28 percent tax bracket, the short-term gain of $8,180 ($8,688 – $508) is also taxed at 28 percent. Read the following section to see the tax implications if your gain is a long-term gain.

Any gain (or loss) from a short sale is considered short-term regardless of how long the position is held open. For more information on the mechanics of selling short, check out Chapter 17.

Minimizing the tax on your capital gains

Long-term capital gains are taxed at a more favorable rate than ordinary income. To qualify for long-term capital gains treatment, you must hold the investment for more than one year (in other words, for at least one year and one day).

Recall the example in the preceding section with GazillionBucks, Inc. As a short-term transaction at the 28 percent tax rate, the tax is $2,290 ($8,180 multiplied by 28 percent). After you revive, you say, “Gasp! What a chunk of dough. I better hold off a while longer.” You hold onto the stock for more than a year to achieve the status of long-term capital gains. How does that change the tax? For anyone in the 28 percent tax bracket or higher, the long-term capital gains rate of 15 percent applies. In this case, the tax is $1,227 ($8,180 multiplied by 15 percent), resulting in a tax savings to you of $1,063 ($2,290 less $1,227). Okay, it’s not a fortune, but it’s a substantial difference from the original tax. After all, successful stock investing isn’t only about making money; it’s about keeping it too.

Capital gains taxes can be lower than the tax on ordinary income, but they aren’t higher. If, for example, you’re in the 15 percent tax bracket for ordinary income and you have a long-term capital gain that would normally bump you up to the 28 percent tax bracket, the gain is taxed at your lower rate of 15 percent instead of a higher capital gains rate. Check with your tax advisor on a regular basis because this rule could change due to new tax laws.

Don’t sell a stock just because it qualifies for long-term capital gains treatment, even if the sale eases your tax burden. If the stock is doing well and meets your investing criteria, hold onto it.

Coping with capital losses

Ever think that having the value of your stocks fall could be a good thing? Perhaps the only real positive regarding losses in your portfolio is that they can reduce your taxes. A capital loss means that you lost money on your investments. This amount is generally deductible on your tax return, and you can claim a loss on either long-term or short-term stock holdings. This loss can go against your other income and lower your overall tax.

Say you bought Worth Zilch Co. stock for a total purchase price of $3,500 and sold it later at a sale price of $800. Your tax-deductible capital loss is $2,700.

The one string attached to deducting investment losses on your tax return is that the most you can report in a single year is $3,000. On the bright side, though, any excess loss isn’t really lost — you can carry it forward to the next year. If you have net investment losses of $4,500 in 2019, you can deduct $3,000 in 2019 and carry the remaining $1,500 loss over to 2020 and deduct it on your 2020 tax return. That $1,500 loss may then offset any gains you are looking to realize in 2020.

Before you can deduct losses, you must first use them to offset any capital gains. If you realize long-term capital gains of $7,000 in Stock A and long-term capital losses of $6,000 in Stock B, then you have a net long-term capital gain of $1,000 ($7,000 gain minus the offset of $6,000 loss). Whenever possible, see whether losses in your portfolio can be realized to offset any capital gains to reduce potential tax. IRS Publication 550 includes information for investors on capital gains and losses.

Here’s your optimum strategy: Where possible, keep losses on a short-term basis and push your gains into long-term capital gains status. If a transaction can’t be tax-free, at the very least try to defer the tax to keep your money working for you.

Evaluating gains and losses scenarios

Of course, any investor can come up with hundreds of possible gains and losses scenarios. For example, you may wonder what happens if you sell part of your holdings now as a short-term capital loss and the remainder later as a long-term capital gain. You must look at each sale of stock (or potential sale) methodically to calculate the gain or loss you would realize from it. Figuring out your gain or loss isn’t that complicated. Here are some general rules to help you wade through the morass. If you add up all your gains and losses and

• The net result is a short-term gain: It’s taxed at your highest tax bracket (as ordinary income).
• The net result is a long-term gain: It’s taxed at 15 percent if you’re in the 28 percent tax bracket or higher. Check with your tax advisor on changes here that may affect your taxes.
• The net result is a loss of $3,000 or less: It’s fully deductible against other income. If you’re married filing separately, your deduction limit is $1,500.
• The net result is a loss that exceeds $3,000: You can only deduct up to $3,000 in that year; the remainder goes forward to future years.