As with any financial decision, it’s important to consider the ways in which your investment portfolio impacts your tax burden. If you had capital gains or were paid dividends from stocks, ETFs, mutual funds, or index funds held in a normal brokerage account, there’s a good chance you’ll owe taxes on that income.
Understanding how stocks are taxed and being strategic about your investments can save you a lot of money in both the short and long term. The good news is that, with some careful tax planning, you can minimize your tax burden without giving up the benefits of building wealth through investing in stocks.
Capital Gains Taxes
A “capital gain” is the profit you make when you sell a capital asset for more than you paid for it. Capital assets can include anything from stocks and bonds to real estate and precious metals. Capital gains are taxed according to how long you’ve owned the asset before you sell it. In most cases, long-term capital gains are taxed at a lower rate than short-term capital gains.
Short-Term Capital Gains Tax
The short-term capital gains tax applies to assets that you owned for one year or less. Short-term capital gains are taxed at the same rate as your other taxable income.
Long-Term Capital Gains Tax
The long-term capital gains tax applies to assets that you owned for more than one year. Depending on your income and filing status, your long-term capital gains tax rate will be 0%, 15%, or 20%.
Taxes on Dividends
Generally, any dividend income you earn from stocks, bonds, mutual funds, or index funds is taxable. For tax purposes, dividends (payments from companies and funds to share profits with their stockholders) are categorized as either qualified or nonqualified (ordinary). Most dividends paid by domestic companies, and some paid by foreign companies, are qualified. However, dividends paid by REITs and other pass-through entities are generally considered nonqualified.
Nonqualified dividends (also known as ordinary dividends) are taxed at the same rate as your regular tax bracket, while qualified dividends are taxed at the capital gains rate, which (depending on your taxable income and filing status) is usually 0%, 15%, or 20%.
How to Lower Your Taxes on Stocks
There are a lot of moving parts when it comes to effective tax planning, and it would be impossible to cover them all here. But broadly, there are three things you should consider first if you’re looking to minimize the taxes you pay on stocks.
Hold your assets for at least one year.
Unless you have a good reason to sell more quickly, it’s generally beneficial to hold stocks for at least one year before selling. Doing so allows you to pay the long-term capital gains tax rather than the short-term one, which is much higher for most taxpayers. Holding your assets for at least one year also makes dividends more likely to be considered qualified, which likewise reduces most people’s tax burden significantly.
Consider a tax-advantaged account.
While there are plenty of reasons to invest in a normal brokerage account (perhaps you want to access your funds prior to retirement, for example), there are some clear tax benefits to investing in a traditional IRA, Roth IRA, or a 401(k).
Capital gains and dividends are tax-deferred when held in a traditional IRA, meaning you won’t pay any taxes on them until you withdraw your funds. With a Roth IRA, your contributions have already been taxed, so your money grows tax-free and you don’t have to pay taxes on withdrawals in retirement.
Similarly, a standard 401(k) allows you to deduct contributions from your taxable income, and you don’t pay any taxes on gains or dividends as long as the money remains in the account. A Roth 401(k), on the other hand, is funded with income that has already been taxed. This means your taxable income for that year is a bit higher, but when it comes time to withdraw your funds, you won’t pay any taxes.
Use capital losses to offset gains.
The IRS allows you to subtract any capital losses from your gains. This reduces the amount of income that’s subject to the capital gains tax. If your net capital losses exceed your net capital gains, you can deduct up to $3,000 (or $1,500 if you’re married and filing separately from your spouse). If your net losses exceed $3,000, you can carry the remainder forward and claim it on a future year’s tax return.
Tax Planning Tailored to Your Financial Goals
Are you looking for ways to reduce your tax burden and make the most of your investments? At Chatterton & Associates, we know there’s no one-size-fits-all approach. We believe your family’s unique financial goals should guide your tax plan and all of your financial decisions. That’s why we work collaboratively with you to develop a comprehensive financial strategy that is tailored specifically to you. Whatever your goals, our team of professionals can help you develop a plan to achieve them.
Contact us today to get started.
The Team at Chatterton & Associates
Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Federal tax laws are complex and subject to change. This information is not intended to be a substitute for specific individualized tax or legal advice. Neither Royal Alliance Associates, Inc., nor its registered representatives, offer tax or legal advice. As with all matters of a tax or legal nature, you should consult with your tax or legal counsel for advice.