When you invest in stocks, there are two ways for you to make money. The first is by selling your stock for a price per share that's higher than what you initially paid, and the second is by holding the stock and collecting dividends. Though capital gains and dividends can both be sources of investment income, they cannot offset one another for tax purposes.
When you buy a stock for a certain price and then sell it for a higher price, your earnings are known as capital gains. Capital gains fall into two categories that have specific tax implications. Short-term capital gains are gains on investments held for a year or less, while long-term capital gains are gains on investments held for a year or longer. The primary difference between the two is that short-term capital gains are taxed as ordinary income, while long-term capital gains are taxed at a lower rate. For most U.S. taxpayers, the 2016 long-term capital gains tax rate is 15%.
Let's say your salary is taxed at 25%, and that you sell your shares of Company X for a $2,000 profit. If you hold those shares for only 10 months before selling them, you'll lose 25%, or $500, of your profit to short-term capital gains taxes. On the other hand, if you hold those shares for 12 months and a day and then sell them, if you're like most Americans, you'll only lose 15%, or $300, of your profit to taxes.
A dividend is a share of a company's proceeds that's distributed to investors. If you hold stock in a company that performs well, that company might issue you a certain amount of money for every share you hold. The dividends you receive are subject to taxes, but the amount you'll pay depends on the type of dividends in question.
Qualified dividends are taxed at the current long-term capital gains rate, which, for most taxpayers, is 15%. On the other hand, non-qualified dividends are taxed as ordinary income. Most dividends paid from typically structured U.S. companies are considered qualified provided you meet the requirements for having held the stock long enough. If you've owned a stock for over 60 days during the 121-day period that begins 60 days prior to the ex-dividend date, that stock's dividends will generally be qualified.
If you receive $2,000 in qualified dividends over the course of a year, and you're like most Americans, you'll only lose 15%, or $300, of your dividend income to taxes. But if your dividends aren't considered qualified, and your salary is typically taxed at 25%, you'll lose 25%, or $500, of your dividend income to taxes.
Offsetting capital gains with capital losses
Capital gains and dividends can't offset one another because they're both a way of making money on an investment. However, capital losses can be used to offset gains. When you buy a stock and then sell it for a price that's lower than what you paid, it's considered a capital loss.
Any time you lose money on an investment, that loss can be used to offset money you make on an investment. Capital losses are initially used to offset gains of the same nature, which means short-term losses are first used to offset short-term gains, and long-term losses are first used to offset long-term gains. However, either type of net loss can then be used to offset the other type of gain.
Let's say you have $2,000 in short-term capital losses, $1,000 in short-term capital gains, and $1,500 in long-term capital gains. You'd first use that short-term loss to essentially eliminate that short-term gain for tax purposes. Then, you'd take the remaining $1,000 in losses and use it to cancel out $1,000 in long-term capital gains, leaving you with just $500 in long-term gains to pay taxes on. Furthermore, if you're left with a net capital loss for the year after offsetting all capital gains, you can use up to $3,000 of that loss to offset your regular taxable income, including income you receive from dividends.
Ready to start your investing journey? The Motley Fool's Broker Center can help you find the best broker for your investing needs.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center, in general, or this page, in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!