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Introduction to Taxes for Stock Investors

It’s good to know in advance the tax basics on ordinary income, capital gains, and capital losses because they may affect your stock investing strategy. 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 — 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.

      Note: At the time of writing, a provision in the Patient Protection and Affordable Care Act, signed into law in 2010, may push the tax rate on dividends to almost 45 percent (yikes) so stay tuned (it may or may not be repealed or modified by the time you read this). Be sure to check with your accountant on this one.

    • 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 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 is reduced. Get more information on capital gains in IRS Publication 550.

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”). Until you sell, that gain is “unrealized.” Time your stock sales carefully and hold on to stocks for at least a year 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). 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.

Any gain (or loss) from a short sale is considered short term regardless of how long the position is held open.

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