Do you make money with stocks and other investments? If so, be sure to set aside some of your profits for your taxes.
When you sell your shares for profit or earn dividends, you are subject to capital gains tax. In other words, these taxes apply when you sell an investment for more than you paid. You owe capital gains tax depending on how long you held the stock before selling it and your tax bracket. I will explain more below.
How Stocks Are Taxed: Understanding Capital Gains
When you sell shares for profit, it’s called a capital gain. Investors must report capital gains from the sale of securities to the Tax Service (IRS) on an annual tax return. Profits from shares are not taxable until they are sold. In addition, your shares are subject to different tax rates depending on how long you hold your investment.
Plus, check out this capital gains tax calculator to find out how much of your profits will go to federal and state taxes.
You also need to know whether or not the stock you own is paying dividends. In addition, it is important to know whether your dividends are ordinary or qualified. InvestmentU’s BJ Cook explains how stock market transaction taxes work on dividends…
Dividends paid to shareholders are taxable income. However, there are ways for investors to reduce taxes from dividend income. Some dividends are taxed by the IRS as ordinary income. The regular income rate is the same as a paycheck.
Some dividends are “eligible”. Qualified dividends are taxed at the capital gains rate. The capital gains rate is 0%, 15% or 20%, well below ordinary tax rates. For a dividend payment to be considered an eligible dividend, the dividend must meet specific criteria.
- A US corporation or qualifying foreign corporation 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 the calculation of dividends is confusing, you should consult your financial advisor before investing. However, learning how to calculate stock taxes with capital gains is much simpler. So, let’s start with the long-term capital gains…
How are stocks taxed with long-term capital gains?
Capital gains on investments held for more than one year are long-term capital gains. The long-term capital gains tax rates are currently 0%, 15% or 20% depending on your tax bracket. Here’s how to break down your tax rate by filing status and income.
2022 long-term capital gains tax rates
| Filing status | 0% Rate | 15% rate | 20% rate |
|---|---|---|---|
| Alone | 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 |
| Groom 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 is an example to break it down further. Let’s say you’re single and have an income of $50,000 in 2022. You buy 15 A shares for $3,000. After two years, you decide to sell your A shares 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 is not 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 particular tax rate. Instead, profits from short-term capital gains are taxed at the same 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 registrants | Married couples file joint returns | Married couples file separately | heads of families |
|---|---|---|---|---|
| ten% | $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 is an example to break it down further. Also, I’ve referenced the example above for simplicity. Let’s say you’re single and have an income of $50,000 in 2022. You buy 15 A shares for $3,000. After two months, you decide to sell your A shares 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 can, it may be beneficial 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 above the income threshold, they will have to pay additional tax. Thus, high-income earners pay an additional 3.8% net investment income tax (NIIT) for long-term or short-term capital gains. The income thresholds are as follows:
Income threshold
| Filing status | Income threshold |
|---|---|
| Alone | $200,000 |
| Married filing jointly | $250,000 |
| Groom filing separately | $125,000 |
| head of household | $200,000 |
| Eligible widow(ers) with dependent children | $250,000 |
You might feel overwhelmed by the amount of tax on your stock market profits. However, there are ways to avoid the way stocks are taxed…
How to Avoid Stock Taxes
Although you cannot avoid taxes, you can minimize them. The simple solution is to hold investments for more than a year before selling them to take advantage of long-term rates of appreciation. However, there are other ways to avoid stock taxes if you make 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 tax.
- 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 reduce your taxable income. As a result, you reduce your income tax expense for the current year.
- Use tax-loss harvesting. Tax loss harvest it is when an investor intentionally sells stocks or other securities at a loss. Therefore, these tax losses may offset the impact of capital gains from the disposal of other shares.
Also, check out this article for more ways to avoid capital gains tax on stocks. While you can’t avoid stock taxes entirely, these methods can help reduce your profit or taxable income. However, it is important to keep control of your tax account.
The last line on how actions are taxed
Calculating tax and the process of paying 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-term and short-term capital gains and dividends work. For this reason, you can plan ahead to reduce and pay your tax bill.
Also, for tax-exempt investments, consider reviewing this article to begin understanding tax-exempt bonds.
Aimee Bohn is a graduate of the College of Business and Economics at Towson University. His background in marketing research helps him uncover interesting trends. For the past year, his main focus has been researching IPOs and other trends.
