That said, there is no legal or moral reason for you to pay any more than you are legally required to pay. With some planning and fore knowledge, you can keep your tax bill for your stock investing to a minimum.
This is not an article on tax dodging or evasion, nor is it a substitute for competent tax counsel for complex tax issues. I have an agreement with my tax attorney friends – I don’t practice tax law and they don’t sue me. So far, it’s working out pretty well.
There are two main ways income or profits from investing in stocks may be taxed:
- Capital gains tax
- Dividend income tax
Capital Gains TaxA capital gain occurs when you sell an asset for a profit. That asset could be a house, land, machinery, stock, or a bond. When that happens, the capital gains tax comes into play. Since we are discussing stocks, I’ll stick with how the tax applies to investing.
You figure the capital gains tax on the difference between your “basis” in the stock and the sales price. This difference is your profit or loss. The basis is usually what you paid for the stock, however if you inherit the stock, the basis is the price of the stock on the day the owner died.
If the difference between the basis and the sales price is negative, in other words, you lost money; you have a capital loss, which you can use to offset capital gains.
There are two types of capital gains:
- Long-term Capital Gains
- Short-term Capital Gains
Long-term Capital GainsYou must hold the stock at least one full year to qualify for the long-term capital gains rates. This is extremely important and I encourage you to make absolutely sure by holding the stock one-year and a day at least.
The tax on a long-term capital gain is currently 15% if you are in the 25% income tax bracket or higher and just 5% if you are in the 15% or lower tax bracket.
As you will see, qualifying for the long-term rates is important.
Short-term Capital GainsIf you hold a stock less than one year before selling it, the IRS classifies the sale as a short-term capital gain and taxes the profit as ordinary income. This means you could pay 25% or much higher of your profit in taxes.
Unless there is a compelling reason, hold on to the stock long enough to qualify for the long-term capital gains rates.
Dividend TaxCompanies that distribute profits through dividends create a taxable event for you. The IRS taxes dividends at 15%, but this is a tax-relief provision that could expire after 2011 if not renewed. Otherwise, dividends may be considered ordinary income and taxed at your current rate.
There is not much you can do to avoid some tax on dividends, unless you hold your stock in a qualified retirement plan and have a dividend reinvestment plan.
Tax PlanningIf you have made sure all of your capital gains qualify as long term, your next possibility is to look at any losing stocks you may want to dump. You can take a capital loss in the same year you have a gain and offset it.
This is one of the reasons the stock market some times dips toward the end of the year as investors dump losing positions to offset gains. However, don’t sell a stock just for tax reasons. If there is good reasons to expect the stock will rebound, it doesn’t make much sense to sell it.
Wash RuleThe IRS has a rule in place to prevent investors from selling a stock in a losing position to offset a gain, only to turn around and buy the stock right back.
It is called the “wash rule” and it says you can’t sell a stock and buy it back within 30 days and claim a capital loss. If you sell a stock and buy it back within 30 days, the IRS will disallow the capital loss and you will lose the offset.