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There are plenty of opportunities for investors to make money in the stock market. However, if there's one thing that can cut into those earnings, it's taxes. Every time an investor sells a security, the IRS will also want their cut, so it’s important to know what rules will apply.
As a general rule, stock market investments are taxed at a slightly more favorable rate than ordinary income. However, the qualifications for meeting this special tax rate will depend on a variety of factors, most importantly being how long the security has been owned.
In this post, we'll explore what types of taxes apply to stock market investments. We’ll also go through some tips about what can be done to potentially lower them.
How Are Stock Market Investments Taxed?
To better appreciate how securities are taxed, an investor will first want to fully understand how the regular tax system works.
In the U.S. we have what’s called a progressive marginal tax rate. This is just a fancy way of saying that the more money a person makes, the higher their tax rate will be.
Ordinary income (i.e., the money you earn when you receive a paycheck from work) is taxed according to a system of seven federal income tax brackets:
- 10 percent
- 12 percent
- 22 percent
- 24 percent
- 32 percent
- 35 percent
- 37 percent
Each bracket has a different income threshold depending on your tax filing status (i.e., single, married filing jointly). As each limit is reached, the excess earnings are taxed according to the rate in the next highest bracket.
For example, a single filer can expect to pay the following rates on their 2022 tax return:
- 10 percent for income between $0 and $10,275
- 12 percent for income between $10,275 and $41,775
- 22 percent for income between $41,775 and $89,075
- And so on …
Now that we understand how regular taxes work, let’s look at how they’re different for stock market investments.
Long Vs Short-Term Capital Gains
A capital gain is when someone sells an asset such as a stock or ETF (exchange-traded fund) for more than they paid for it.
For example, if an investor bought stocks for $1,000 and then later resold them for $1,500, they would have a capital gain of $500. When this occurs, the IRS sees this as a taxable event and one of two tax rates will apply based on whether the gain is considered to be short or long-term.
A long-term capital gain is when the asset has been held for over one year before being sold. Investments that meet this criterion are subject to more favorable tax rates consisting of just three brackets: 0, 15, or 20 percent.
To put this into context, compare the long-term capital gains tax rates for a 2022 single filer against those in the example we gave above for ordinary income:
- 0 percent for gains between $0 and $41,675
- 15 percent for gains between $41,675 and $459,750
- 20 percent for gains between $459,750+
Clearly, someone making all of their income from long-term stock market investments will pay fewer taxes than another person who earns a standard paycheck. For example, it's well known that Tesla CEO Elon Musk makes the majority of income from the shares of the companies that he owns. However, an investigation between 2014 and 2018 found that his true tax rate was 3.27 percent while the average American paid a tax rate of 13.3 percent.
By contrast, a short-term capital gain is when an investment is held for one year or less. An example of this would be someone who bought a meme stock and then sold it a month later after the share price significantly increased in value.
Short-term capital gains are simply treated as ordinary income. They do not receive the same favorable tax rates as long-term capital gains and are instead taxed just like the money in your paycheck.
It’s important to remember that short-term capital gains can be triggered even if the investor just makes a trade. For example, someone who buys an ETF, changes their mind, and trades it for another one a few months later will pay tax on their short-term capital gain if the asset grew in value.
Qualified vs Nonqualified Dividends
Not all stock market investments have to be sold to produce income. Some assets pay dividends, a small percentage of the company’s profits which is distributed back to the shareholders. When an asset pays dividends, then this is also considered taxable income by the IRS.
Similar to long and short-term capital gains, the IRS classifies dividend payments as one of two types: qualified and nonqualified. Qualified dividends are taxed at the same favorable rates as long-term capital gains whereas nonqualified dividends (also called ordinary dividends) are taxed as ordinary income.
- Be paid by a U.S. company or a qualifying foreign company.
- Not be listed with the IRS as one that does not qualify.
- Have been owned for more than 60 days during the 121-day period that starts 60 days before the ex-dividend date.
Sometimes understanding this criterion can be tricky, so it’s best to talk with a tax professional if you’re unsure whether or not the dividends you’re receiving are considered qualified.
5 Ways For Lowering Your Taxes On Stocks
Savvy investors will frequently use the IRS rules for capital gains and dividends to pay a lower tax bill. Here’s how you can too.
1. Invest Inside Your Retirement Accounts
Retirement plans such as IRAs and 401ks are what’s called “tax-advantaged”. This means that when a security is traded or produces dividends, these are not considered taxable events as long as the assets remain locked up inside the retirement plan.
2. Hold Your Stocks For Longer Than One Year
Whenever possible, investors should hold their securities for greater than one year so that they will qualify for the more favorable tax rate. The best way to do this is to invest in assets for the long term. Like the great Warren Buffett once said, “If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes.”
3. Offset Your Gains With Losses
One of the unique benefits of stock market investments is that the IRS will let you subtract a portion of your losses against your gains. Therefore, if you’ve got investments that you believe have no chance of a comeback, then it may be worthwhile to consider selling them at a loss.
A capital loss is defined as when an investor sells a security for less than what they paid for it. Because it’s recognized that investors frequently both make and lose money from the sales of their securities, the IRS will allow the offset capital gains by $3,000 of losses. If an investor has capital losses greater than $3,000, then they can carry over the excess into the following year.
4. Structure Your Income Sources
Since an investor's income will generally be a mixture of ordinary income, capital gains, and dividends, it's important to be strategic about where that money is coming from.
For instance, take a single-filer who earns $50,000 from long-term capital gains and qualified dividends. After taking a standard deduction ($12,950 for 2022), they'd have $37,050 of taxable income. This would fall into the 0 percent capital gains tax bracket, and so this individual would have a $0 tax bill. However, if they had also worked a part-time job and also had some ordinary income, then this may have pushed them into the 15 percent capital gains tax bracket.
5. Get To Know Your Dividends
While the dividends from most U.S. companies will likely be considered qualified, investors need to appreciate how other types of dividends may also be treated.
For instance, dividends from REITs (real estate investment trusts) are very desirable because they typically pay higher yields than traditional stocks. But these are also classified as unqualified dividends because of the tax structure of the REIT. Therefore, they’ll be treated as ordinary income on your tax return.
Understanding which securities to invest in and how the taxes will impact your strategy can be complicated. However, you don’t have to figure it all out alone. You could work with experts such as those from Market Insiders.
Market Insiders is a coaching program where you’ll have a weekly group call with an industry expert. During this call, you can ask questions and have an open discussion with both the coaches as well as the other members. You’ll learn how to be more strategic about your long-term goals as well as develop the right skill set for picking your own investments.
Will My Stock Market Investments Be Taxed?
Your stock market investments will be taxed according to the rules of the IRS. In general, those which are considered long-term capital gains and qualified dividends will receive favorable tax treatment. However, any that are classified as short-term capital gains or nonqualified dividends will be taxed as ordinary income.
Investors who understand the IRS rules can use them to their advantage to lower their tax bills. This will generally be strategies such as holding the stock for longer than one year and understanding the source of your dividends. Investors can avoid taxes by using their retirement accounts, using their losses to offset their gains, and being strategic about their income sources.
Stock market investments can be a great way to build your wealth. However, those earnings can quickly become eroded by taxes. That’s why it’s always in the best interest of an investor to understand what impact taxes will have on their strategy, plan for them, and then take steps to minimize how much they’ll owe.