Only two things in life are certain: death and taxes. So when it comes to stocks, the answer is an absolute “yes, you will pay taxes on stocks”.
Stocks and other investments have unique tax implications that make it a more complicated experience than simply taking out a chunk of your paycheck.
What Will You Pay Taxes On?
While investment taxes are more complicated to calculate than payroll taxes, they essentially function the same way. That is, you’ll pay taxes anytime you make money. That includes any money earned through trades or through dividend payments. Anytime you make money investing, you will have to hand over a cut of that profit to the federal government. You’ll also likely have to pay state and local taxes, but that depends on where you live.
Capital gains refer to the taxes you’ll pay when you “actualize” your gains. When you look at your brokerage account and see that a stock you’ve bought has increased 50% since you bought it, those are theoretical gains. That isn’t money you can use, because at this point you only own the stock, not the cash value of that stock. When you sell, then those theoretical gains are “actualized,” and the cash is added to your account. You will pay taxes on the cash.
There are two kinds of capital gains taxes, long-term and short-term. If you hold a stock or ETF for exactly one year or less, then any profits from the sale are considered short-term capital gains. If you hold the stock for more than a year, then profits are considered long-term capital gains.
While you’re holding a stock or ETF, your gains are theoretical, but any dividend payments are very real. Dividends are deposited into your account as cash, and when it comes to tax time, you can expect to pay taxes on all that cash that was dropped into your account throughout the year.
Just like capital gains, there are two types of dividends, as far as the tax burden is concerned. The two types are called “qualified” and “ordinary” dividends. Qualified dividends must meet a set of criteria. One piece of criteria is the holding period — qualified dividends come from stocks you’ve held for at least 60 days before receiving the payment. The dividends must also be from a U.S. company or a qualifying foreign company. Finally, the IRS keeps a list of dividends that don’t qualify, so you’ve got to make sure your dividends aren’t on that list.
How Are Taxes Calculated?
Now that you know the situations in which your investments will be taxed, it’s time to get down to brass tacks: how much?
For short-term stocks (held for one year or less) that you sell for a profit, your capital gains will be taxed at the same rate as your income bracket. This is a sliding scale that goes up as your income level does, ranging from 10% to 37% (for the 2020 tax year). The 10% rate only applies to single individuals who earn less than $9,875 in a year. The 37% rate applies to single individuals who earn more than $518,401 in a year.
According to the Census Bureau, the median household income in the U.S. is about $62,000, and individuals who earn that will pay a 22% income tax rate when they file taxes for 2020.
If you hold onto the stock or ETF for more than a year, then you pay a special capital gains rate. In nearly every case, the special capital gains rate will be lower than your income bracket rate, so investors who are primarily concerned with taxes will often hold their stocks for more than a year before selling. Long-term capital gains are either taxed at 0%, 15%, or 20%. The vast majority of investors will pay that 15% rate, it covers all income levels between roughly $40,000 and $441,500. For those who earn $40,000 or less in a year, long-term capital gains aren’t taxed at all.
The rule for dividends is similar. Ordinary dividends are taxed as regular income with the regular income tax bracket. Qualified dividends get a special tax rate, which is equal to the long-term capital gains rate. The brackets are the same, so people earning $40,000 or less won’t be taxed at all on qualified dividends. The highest-earning Americans will pay 20% on qualified dividends.
Can You Avoid Paying Taxes on Investments?
No, you can’t avoid paying taxes altogether. Just like dodging income or property taxes, that’d be illegal, and you can expect the IRS to come after you for it. However, there are steps you can take and strategies you can use to lower your tax burden. That’s entirely legal, and in some cases, the government even encourages it.
Invest in a Retirement Account
The government doesn’t want you to be a burden on society when you surpass your working years, and that’s why it offers massive tax breaks for people who save for retirement. If you don’t plan on withdrawing money until you’re older than 59½, then you can legally avoid a significant amount of taxes by holding the investments in a retirement account.
There are multiple types of retirement accounts, and each has slightly different tax benefits. Traditional individual retirement accounts (IRAs) and work-sponsored 401(k) plans give you a tax break upfront. With a Roth IRA, you’ll have to pay taxes on any dollars you contribute, but that money will grow tax-free. As long as you wait until retirement, you can withdraw the money in your Roth without cutting the government in on the profits.
Hold onto Stocks for More Than a Year
If you can’t wait until retirement, you should try to wait at least a year and a day before selling any stocks or ETFs you hold. You benefit two ways from this. For one, your profits on the sale will be taxed at the special long-term capital gains rate. This is a much lower rate for most traders, and if you don’t earn more than $40,000 in a year, then you won’t pay any taxes at all.
Secondly, as long as you’re holding common stock of a U.S. company, many of your dividends will likely be qualified dividends. Your first dividend payment might fall under the 60-day mark that makes it an ordinary dividend with a higher tax rate, but any dividends after those first 60 days will be qualified dividends taxed at a lower rate.
Take Advantage of Losses
You should always aim to make money on your investments, not lose it, but the reality is that everyone makes a bad investment from time to time. If you made such an investment, and you don’t see how it’ll ever turn around and earn you a profit, you can sell it at a loss and write off the loss on your taxes. This is known as tax-loss harvesting, and you can offset up to $3,000 in non-investment income through this method every year.
If you pursue this strategy, make sure to avoid violating the wash-sale rule. A trader violates the wash-sale rule and can’t take advantage of tax-loss harvesting if they purchase the same (or a “substantially similar”) security within 30 days of selling the security for a loss. This rule was created to prevent traders from abusing tax-loss harvesting. Without it, traders could simply sell for a loss, then rebuy the securities right away — enjoying the tax benefit without losing out on any upward momentum the stock later enjoys.
Consider Passively Managed Index Funds
If you buy ETFs and mutual funds, then you will be taxed on all the trades that managers make on the underlying holdings. Not all managers treat their funds the same way, and ETFs are broadly broken up into two groups along these lines: passively managed and actively managed.
Passively managed funds trade underlying securities less often. For example, a passively managed index ETF might rebalance its holdings once per quarter to ensure that it’s accurately reflecting the index it tracks. This rebalancing would be subtle — an index usually doesn’t fluctuate that much within a quarter — so the ETF’s holdings are probably already very close to representing the index. An actively managed value ETF, on the other hand, would make a trade anytime the ETF managers see an opportunity. All of these trades invite more opportunities for taxes. By seeking out passively managed funds, you can minimize your exposure to capital gains taxes.
Consider Municipal Bonds
While most of these strategies apply to stocks and ETFs, a well-balanced portfolio should include bonds, and you can limit your tax exposure on those holdings, as well. When you receive interest payments from corporate bonds, those payments will be taxed as normal income. You can avoid state and local taxes with Treasury bonds, but you’ll still have to pay federal taxes.
If your primary goal is tax efficiency, then municipal bonds are your best investment. Municipal bonds, those issued by state and local authorities, are exempt from federal taxes. You can also avoid state and local taxes if you buy municipal bonds that were issued in the state where you live (and pay taxes).
Responsible Tax Strategies Can Fit Into Overall Investment Goals
Keeping these strategies in mind as you consider trades can help reduce your tax burden. Over decades of trading, these reduced tax burdens will help you keep significantly more money in your pocket. However, it’s important to keep the tax strategies in the context of a broader investment goal. Avoiding taxes should never be your primary purpose for placing a specific trade. Rather, most tax-savvy investors consider how they apply tax-saving strategies to the goals they’re already pursuing.
Keep these tax considerations in the back of your mind as you look for opportunities that fit your investment goals and risk tolerance levels. Many of these points overlap with investment strategies that have nothing to do with taxes. For example, most traders (especially beginning traders) should hold onto investments long enough that they automatically enjoy tax benefits like the long-term capital gains rate.