The Ins and Outs of Taxes on Investments: What You Need to Know
Are you one of the 150 million Americans who have investments? It’s beneficial to make investments for long-term financial success but it can be costly at tax time. Whether you are a long-time investor or just thinking about getting in the game now, understanding the tax implications of your investments will help in planning ahead to reduce your tax liability and reporting your taxable income when it comes time to file your income tax return.
Investments in your portfolio that increase in value do not create a taxable event. It’s not until your investments generate income or you sell a security asset, such as stock, for more than the price you purchased it, that a taxable event occurs. The profit you make when you sell an asset is called a capital gain. Investment income includes interest and dividends. We’ll focus on these two important types of taxable income as well as ways to minimize your tax liability and maximize your tax refund at tax time.
Taxes on Capital Gains:
The IRS classifies capital gains and losses in two categories: short-term and long-term. When stock is sold within a year from when it is purchased, the capital gain or loss is considered short-term, while stock held for more than a year before it is sold results in a long-term gain or loss.
The good news is that the gain from sales of your long-term investments is taxed at a lower rate than ordinary income such as wages, retirement income, and income from self-employment.
Your long-term net capital gain will be taxed at 0% if your taxable income is less than or equal to $41,675 for single and married filing separately filing statuses, $83,350 for married filing jointly or qualifying surviving spouse filing statuses or $55,800 for head of household filing status. Long-term capital gains are taxed at 15% if your taxable income is more than $41,675 but less than or equal to $459,750 for single; more than $83,350 but less than or equal to $517,200 for married filing jointly or qualifying surviving spouse; more than $55,800 but less than or equal to $488,500 for head of household or more than $41,675 but less than or equal to $258,600 for married filing separately. In general, long-term capital gains are taxed at 20% if your taxable income exceeds the limits above.
There are a few exceptions where long-term capital gains may be taxed at rates greater than 20%, including capital gains resulting from the sale of collectibles (such as art, coins, stamps, antiques, etc.).
Short-term capital gains are taxed at the same rate as your ordinary income. The highest tax rate for ordinary income is 37%. Income tax planning could impact the timing of when you sell investments, such as stock, for a profit as holding the stock for over a year could lead to substantial tax savings based on the lower capital gains tax rates.
Calculating Taxes on Capital Gains
To calculate the capital gain from the sale of an investment, such as stock, start with the sales price of your stock less any commission or fee you paid on the sale and then subtract the basis of the stock. The basis of a stock is generally the amount you paid for the stock including fees and commissions. If you inherit shares of stock, the basis is generally the fair market value of the stock on the date of death of the person you inherited the stock from.
For example, if last year you bought shares of stocks for $590 with a commission of $10 and at the end of the year the value of the stock was $800, you don’t owe any tax. However, if this year, you sell the stock for $925 and pay a $12 commission, you will be taxed on your capital gain of $313 ($925 proceeds less $12 commission less $600 basis).
Offsetting capital losses with capital gains:
Fortunately, you can offset your capital gains by capital losses incurred in the same year. Capital losses occur when you sell an asset for less than your basis in the stock. “Loss harvesting” is a tax planning technique in which an investor who has capital gains sells stock that is underperforming at a loss during the same tax year in order to offset those gains by the loss of the underperforming stock.
The IRS has established “netting rules” to be followed when offsetting capital gains by capital losses. Long-term losses must be applied to long-term gains (resulting in a net long-term capital gain or loss) and short-term losses must be applied to short term gains (resulting in a short-term capital gain or loss). Any remaining net capital loss can be used to offset the opposite type of net capital gain.
For example, you have the following total gains and losses in the same tax year:
$550 total short-term gains
$600 total short-term losses
$1,200 total long-term gains
$900 total long-term losses
First you determine the net short-term gain or loss by netting your total short-term gains with your total short-term losses, resulting in a $50 net loss. Next you determine the net long-term gain or loss by netting your total long-term gains with your total long-term losses, resulting in a $300 net gain. The $50 net short-term loss can then be netted with the total long-term gain of $300, for a total $250 long-term gain.
Your individual stock transactions are reported on Form 8949 and the totals are transferred to Schedule D where the netting takes place.
Limits on capital losses:
If after netting your capital gains and losses, your losses exceed your gains, you may claim up to a maximum of $3,000 of that loss against your ordinary income in one given tax year. The capital losses of married couples filing a joint return are calculated as if they are one person with the same $3,000 maximum on capital losses. If they file separate returns, the maximum loss they can claim is $1,500. Therefore, all filing statuses except for Married Filing Separate have a loss limitation of $3,000 (the limit is $1,500 if your filing status is Married Filing Separate). Any remaining loss can be carried over to future years.
For example, you have the following total gains and losses in the same tax year:
$750 total short-term gains
$600 total short-term losses
$1,200 total long-term gains
$5,900 total long-term losses
According to the netting rules discussed above, we have a net short-term gain of $150 and a net long-term loss of $4,700. This results in a total net loss of $4,550. $3,000 of this loss can be claimed as a deduction on your current year tax return and the remaining $1,550 can be carried forward to future years to offset capital gains or to be included in a net loss.
Losses that are carried forward retain their long-term or short-term character and will be applied against gains of the same type in future years. Losses can be carried forward for an unlimited number of years until they have been completely used.
Tax Implications of Wash Sales:
While “loss harvesting” is a powerful tax planning tool, there are rules in place such as the “wash sale rule” to prevent taxpayers from artificially generating capital losses to offset capital gains. A wash sale is a sale of a stock at a loss and repurchase of the same or substantially identical security stock before or after.
Losses from such sales are not deductible in most cases under the Internal Revenue Code. To avoid a wash sale, you must not buy the same or substantially identical stock within 30 days of selling the security at a loss. If you do, the loss will be disallowed for tax purposes.
Taxes on Investments in Tax-Deferred or Tax-Exempt Plans:
One of the biggest advantages of a tax-deferred or tax-exempt retirement plan is that when stock is traded for a profit within these plans or dividends and interest is earned, it doesn’t trigger a taxable event. For tax-deferred plans, such as 401K plans and traditional IRAs, when you withdraw money from the plan you are taxed on the amount withdrawn is taxed at the same rate as your ordinary income. For tax-exempt plans, such as Roth IRAs and Roth 401Ks, there is no tax on the amount you withdraw.
For tax-deferred retirement plans, this results in the profits on securities sold that have accumulated over the years, being taxed as ordinary income when they are withdrawn. This can still be advantageous if your withdrawals are made after you have retired and your income is taxed at a lower rate, especially as your initial contributions are not taxable when they are made.
Cryptocurrency taxed as capital gains:
Taxpayers are sometimes surprised to learn that cryptocurrency can be taxed as capital gains property, which means that you will owe taxes on the difference between the sale price and the purchase price of the cryptocurrency. Capital gains are also realized when you use a cryptocurrency to make a purchase. In this case the price you purchased the item for is considered the sales price of the cryptocurrency. If you held the cryptocurrency for more than a year, your capital gain will be taxed as a long-term capital gain and if you held the cryptocurrency for less than a year, your capital gain will be taxed as a short-term capital gain.
For example, you purchase a cryptocurrency for $900. Fourteen months later you use the cryptocurrency to purchase an item for $3,800. Your capital gain is $2,900 ($3,800 cost of the item less the $900 the cryptocurrency was purchased at) and it is categorized as a long-term capital gain as the cryptocurrency was purchased over 12 months prior to the purchase.
Cryptocurrencies are a relatively new asset class, and IRS has increased its efforts toward enforcing income tax rules on cryptocurrency. Currently, all taxpayers filing a U.S. Income Tax Return need to inform the IRS if they received, sold, exchanged or otherwise disposed of cryptocurrency.
Tax Impact of Selling a home:
Some people consider their home to be their biggest asset. When you sell a home for more than your basis in the home, this may create a capital gain. If you sell your primary residence, you may be able to exclude up to $250,000 of the gain from your taxable income. Married couples can claim $250,000 each for a maximum exclusion of $500,000. To qualify for this exclusion, you must have owned and lived in the home as your primary residence for at least two of the five years before the sale. You can use this exclusion every two years, as long as you owned and lived in your home for two of the five years leading up to the sale.
Any gain over the exclusion amount is reported as a capital gain on Schedule D. Like any other capital gain, to determine the amount of gain, you need to subtract the adjusted basis of the house from the selling price. In the case of a home, the adjusted basis is generally the original cost of the home plus the cost of capital improvements you made to the home.
Tax Impact of Investment Income:
Investment income is income earned from an asset held for investment before you sell the asset creating a capital gain or loss. In the case of stocks and bonds, this is usually in the form of dividends or interest.
Taxes on Dividend Income:
Dividend income is generated when a corporation you are invested in distributes property to you. Most dividends are paid in cash, but they can also be paid as stock of another corporation (known as a stock dividend) or as any other property.
Certain dividends are considered “qualified dividends” and are taxed at the favorable long-term capital gain rate rather than at the higher ordinary income tax rate.
If you receive a dividend from a corporation or a mutual fund, this will be reported to you on Form 1099-DIV. Form 1099-DIV will clearly indicate any portion of your dividend income arising from qualified dividends. You will then use this information to report the income on your tax return.
Taxes on Interest Income:
Interest income is earned from investments in bank accounts, certificates of deposits (CDs), money markets, and bonds. Interest earned from U.S. Savings bonds is taxable on your federal return but is not taxable on a state or local tax return. Interest earned from municipal bonds in not taxable on your federal return, however, only interest from municipal bonds from your home state will be tax-exempt for state purposes; interest paid on bonds from outside your home state are typically subject to state income tax.
For all types of investments, understanding how timing of transactions affects your taxable income rates is necessary for lowering your tax liability. A reduced tax bill each year is important for long-term financial success and building your wealth. Understanding the tax implications for your investments can help accumulate your financial gains more quickly and sustainably.
About the author: Starra Sherin is a CPA and has a Master of Business Administration. Starra began her career at PwC over 25 years ago and has been immersed in the world of taxation ever since.
