How Are Stocks Taxed? A Guide for Capital Gains
Are you making money from stocks and other investments? If so, make sure you set aside some of your profit for your taxes.
When you sell your stock for a profit or earn dividends, you are subject to capital gains taxes. In other words, these taxes apply when you sell an investment for more than you paid. You owe capital gains tax based on how long you held the stock before selling it and your tax bracket. I’ll explain more below.
How Are Stocks Taxed: Understanding Capital Gains
When you sell stocks for a profit, it’s called a capital gain. Investors must report capital gains earned from the sale of securities to the Internal Revenue Service (IRS) on an annual tax return. Profits from stocks are not taxable until they are sold. Moreover, your stocks are subject to different tax rates depending on how long you hold your investment.
In addition, check out this capital gains tax calculator to find out how much of your profit will go to federal and state taxes.
You also need to be aware of whether or not the security you hold pays dividends. Moreover, it’s important to know if your dividends are ordinary or qualified. InvestmentU’s BJ Cook explains how taxes on stock trades work regarding dividends…
Dividends paid to shareholders are taxable income. However, there are ways that investors can reduce the taxes that come from dividend income. Some dividends are taxed by the IRS as ordinary income. The ordinary income rate is the same rate as a paycheck.
Some dividends are ‘Qualified.’ Qualified dividends are taxed at the capital gains rate. The capital gains rate is 0%, 15% or 20%, much lower than ordinary income tax rates. For a dividend payment to be considered a qualified dividend, the dividend must meet specific criteria.
- A U.S. company or a qualified foreign company must pay the dividend.
- The dividend cannot be a capital gains distribution of dividends from a tax-exempt organization.
- The investor must hold the stock for 60 days during the 121-day period beginning 60 days before the ex-dividend date.
If calculating dividends is confusing, you should consult with your financial advisor before investing. However, learning how to calculate stock taxes with capital gains is much more simple. So, let’s start with long-term capital gains…
How Are Stocks Taxed with Long-Term Capital Gains?
Gains on investments held for more than a year are long-term capital gains. Long-term capital gains tax rates are currently 0%, 15% or 20% depending on your tax bracket. Here’s how to breakdown your tax rate by filing status and income.
Long-term Capital Gains Tax Rates in 2022
| Filing Status | 0% Rate | 15% Rate | 20% Rate |
|---|---|---|---|
| Single | Up to $41,675 | $41,676 – $459,750 | Over $459,750 |
| Married filing jointly | Up to $83,350 | $83,351 – $517,200 | Over $517,200 |
| Married filing separately | Up to $41,675 | $41,676 – $258,600 | Over $258,600 |
| Head of household | Up to $55,800 | $55,801 – $488,500 | Over $488,500 |
Here’s an example to break it down further. Let’s say you’re single and generate $50,000 in income in 2022. You buy 15 shares of Stock A for $3,000. After two years, you decide to sell your shares of Stock A for $4,600.
So, your capital gain is $1,600. As a result, you would owe $240 (or 15%) in taxes on your $1,600 profit. However, this isn’t the case with short-term capital gains.
How Are Stocks Taxed with Short-Term Capital Gains?
In most cases, short-term capital gains are not subject to any special tax rates. Instead, profits from short-term capital gains are subject to the same tax rate as ordinary income. For 2022, ordinary tax rates range from 10% to 37%, depending on your income and filing status.
For the 2022 tax year, these are the tax brackets by income and filing status…
Federal Income Tax Brackets in 2022
| Tax Rate | Single Filers | Married Couples Filing Joint Returns | Married Couples Filing Separately | Heads of Households |
|---|---|---|---|---|
| 10% | $0 to $10,275 | $0 to $20,550 | $0 to $10,275 | $0 to $14,650 |
| 12% | $10,276 to $41,775 | $20,551 to $83,550 | $10,276 to $41,775 | $14,651 to $55,900 |
| 22% | $41,776 to $89,075 | $83,551 to $178,150 | $41,776 to $89,075 | $55,901 to $89,050 |
| 24% | $89,076 to $170,050 | $178,151 to $340,100 | $89,076 to $170,050 | $89,051 to $170,050 |
| 32% | $170,051 to $215,950 | $340,101 to $431,900 | $170,051 to $215,950 | $170,051 to $215,950 |
| 35% | $215,951 to $539,900 | $431,901 to $647,850 | $215,951 to $323,925 | $215,951 to $539,900 |
| 37% | Over $539,900 | Over $647,850 | Over $332,925 | Over $539,900 |
Here’s an example to break it down further. Also, I’ve referenced the example from above for simplification. Let’s say you’re single and generate $50,000 in income in 2022. You buy 15 shares of Stock A for $3,000. After two months, you decide to sell your shares of Stock A for $4,600. So, your capital gain is $1,600. As a result, you would owe $352 (or 22%) on your $1,600 profit.
If you have the option, it can pay off to hold on to your investment. As a result, you can avoid paying higher taxes on your capital gains. This is especially true for high-income taxpayers who are subject to additional taxes.
How Are Stocks Taxed for High-Income Taxpayers?
If a taxpayer earns over the income threshold, they will have to pay an additional tax. So, high-income earners pay an additional 3.8% net investment income tax (NIIT) for long- or short-term capital gains. The income thresholds are as follows:
Income Threshold
| Filing Status | Income Threshold |
|---|---|
| Single | $200,000 |
| Married filing jointly | $250,000 |
| Married filing separately | $125,000 |
| Head of household | $200,000 |
| Qualifying widow(er) with dependent child | $250,000 |
You might feel overwhelmed by the amount of tax on your stock profits. However, there are ways to avoid how stocks are taxed…
How to Avoid Taxes on Stocks
Although you can’t avoid taxes, you can minimize them. The simple solution is to hold on to investments for more than a year before selling them so you can take advantage of long-term capital gains rates. However, there are other ways to avoid taxes on stocks if you’re making a profit on short-term gains.
- Capital gains are not taxable on investments held in tax-advantaged retirement accounts. With these types of accounts, capital gains or dividends are not taxed as long as they remain in the account. However, when you withdraw money from an IRA or 401(k), you will be subject to income taxes.
- Reduce your taxable income. You can reduce your taxable income by contributing to pre-tax retirement accounts. Making contributions to a traditional 401(k) or IRA will lower your taxable income. As a result, you reduce your income tax liability for the current year.
- Use tax-loss harvesting. Tax-loss harvesting is when an investor intentionally sells stocks or other securities at a loss. As a result, these tax losses can offset the impact of capital gains from the sale of other stocks.
Furthermore, check out this article to learn other ways to avoid capital gains tax on stocks. While you can’t avoid taxes on stocks entirely, these methods can help reduce your taxable profit or income. However, it’s important to stay on top of your tax bill.
The Final Line on How Stocks Get Taxed
The tax calculation and payment process for capital gains and dividends is not a fun part of winning in the stock market. However, the key to managing the process is knowing how long- and short-term capital gains and dividends work. Because of this, you can make plans ahead to reduce and pay your tax bill.
Moreover, for tax-free investments, consider checking this article out to get started on understanding tax-free bonds.
