Investing and Taxes: What Beginners Need to Know

Are you a new investor and curious how your tax bill could be affected? Here’s what you should know before you buy your first stock, bond, or mutual fund.Image source: Getty Images.

There’s a lot to learn when you start investing. For example, new investors need to learn the basics about the types of investments that are available, such as stocks, bonds, and mutual funds. You also need to learn how to choose and open a brokerage account, and how to navigate that brokerage account.  

One thing that is often misunderstood by beginning investors (and even some experienced ones) is taxes. Here’s a primer on how your investments are taxed so you’ll know what to expect as you get started with your investing journey.

When you sell a stock for a profit: Capital gains taxes in a nutshell

Here’s the first thing you should know as a new investor. If you own a stock and the price goes up, you don’t have to pay any taxes. Warren Buffett owns more than $80 billion in Berkshire Hathaway stock and he’s never paid a dime in taxes on any of his shares. In the United States, you only pay taxes on investments that increase in value if you sell them.

A capital gain occurs when you sell an asset you purchase for a profit. For investors’ purposes, capital gains generally occur when you buy an investment at one price and then sell it at a higher price. As an example, if you buy stock for $2,000 and sell it for $2,500, you’ll have a $500 capital gain.

This also applies if you’re profiting from the sale of bonds, mutual funds, ETFs, precious metals, cryptocurrencies, collectibles, you name it. Real estate sold at a profit can be considered a capital gain, but the rules are a bit more complicated and the calculation of a capital gain (if any) depends on whether the property in question is your personal residence.

The IRS classifies capital gains into two main categories for tax purposes. Long-term capital gains occur when you sell an asset that you owned for longer than a year, while short-term capital gains occur when you sell an asset that you owned for a year or less.

For example, if you bought a stock on Jan. 1, 2017 and sold it on Jan. 2, 2018, you owned it for more than a year, and any profit is taxed as a long-term capital gain. On the other hand, if you bought a stock on Jan. 1, 2017 and sold it on Jan. 1, 2018, you didn’t own it for longer than a year, so it becomes a short-term gain. As you’ll see in the next couple sections, long- and short-term capital gains are taxed rather differently.

Long-term capital gains tax rates

As I mentioned, long-term capital gains occur when you sell an investment at a profit and you’ve held it for over a year. In this case, the gains are taxed according to the IRS’s long-term capital gains tax rates, which are 0%, 15%, or 20%, depending on your total taxable income.

Here’s a quick guide to long-term capital gains tax rates for the 2019 tax year (the tax return you’ll file in 2020).

Data source: Tax Foundation. Income ranges represent taxable income, not just capital gains. Married Filing Separately rates calculated as half of those for joint filers.

In addition to the rates listed in the table, higher-income taxpayers may also have to pay a 3.8% net investment income tax. This applies to any investment income, not just capital gains. Dividends, interest income, rental income from real estate, and passive business income are just some other examples of income that counts toward your net investment income.

If you are a married couple filing jointly with adjusted gross income of more than $250,000, your investment income above that threshold is assessed the additional tax. For example, if you and your spouse earn $200,000 from your job and $70,000 from your investments, only the $20,000 that makes your income exceed the threshold is subject to the net investment income tax. For single filers, the threshold for the additional tax is adjusted gross income of $200,000.

Short-term capital gains tax rates

While long-term capital gains receive favorable tax treatment, short-term gains do not. If you earn a profit on an investment that you held for a year or less, it is taxed using the same tax brackets as ordinary income.

Now, the marginal tax rates have become generally lower recently as a result of the Tax Cuts and Jobs Act, but in nearly all cases, short-term gains are taxed at a higher rate than long-term gains.

For reference, here are the 2019 U.S. tax brackets, which apply to short-term capital gains:

Data source: IRS.

What if your capital gains are negative?

Sometimes, you may not have any gains at all when you sell investments. In fact, in some cases, you may find yourself with capital losses.

Here’s how this works for tax purposes. Capital losses can be used to reduce your capital gains. In other words, if you sell a stock at a $5,000 profit but sell another stock at a $1,000 loss, your taxable capital gain for the year will be $4,000.

Long-term capital losses must first be used to offset long-term gains before they can be applied toward short-term capital gains. Conversely, short-term losses must be used to reduce short-term gains before they can be applied toward reducing any long-term gains.

In the event that your capital losses are greater than your capital gains in a certain year, you can use them to offset your other taxable income. This deduction is capped at $3,000 per tax year, but if your net capital losses exceed this amount, they can be carried over to subsequent years.

Dividend taxes: Qualified or not

Just like with capital gains taxes, dividends have two basic classifications for tax purposes -- qualified and ordinary. Qualified dividends are taxed at the long-term capital gains rates, while ordinary dividends are taxed as, well, ordinary income.

To be considered a qualified dividend, two basic requirements must be met. First, the company that paid the dividend must either be a U.S. corporation or a qualified foreign corporation, which generally means that their stock is traded on U.S. exchanges. Second, you must have owned the stock for 60 days during the 121-day period starting 60 days before the stock’s ex-dividend date and ending 60 days afterward. (Preferred stock has a stricter ownership requirement -- 90 days out of the 181-day window beginning 90 days before the ex-dividend date.)

Some dividends are never considered to be qualified. These include dividends from tax-exempt organizations, capital gains distributions, dividends paid on bank deposits (ex. credit unions often pay “dividends” on deposit accounts), and dividends paid by a company on stock held in an employee stock ownership plan (ESOP).

In addition, dividends paid by pass-through entities, such as real estate investment trusts, or REITs, are typically considered to be ordinary dividends, although there are some exceptions.

Interest income

Finally, interest income is also taxable -- typically as ordinary income. This includes interest payments you receive on fixed-income investments (bonds) that you own, as well as any interest your brokerage pays on cash balances in your account.

One big exception is if you own municipal bonds. Generally speaking, the interest paid by municipal bonds is exempt from taxation.

One way to avoid dividend and capital gains taxes

Finally, it’s important to make the distinction between a standard (taxable) brokerage account and an individual retirement account, or IRA.

The tax rules I’ve discussed here only apply to investments held in a taxable brokerage account. IRAs allow you to invest on a tax-deferred basis. This means that each year, you won’t pay any tax on capital gains on the sale of profitable investments, you won’t pay taxes on the dividends you receive, and you won’t report the interest income you receive in your IRA.

Furthermore, with a traditional IRA, your contributions to the account may be tax-deductible and you only pay tax when you withdraw money from the account, in which case your withdrawals are considered taxable income. Roth IRA contributions are never tax-deductible, but qualifying withdrawals are 100% tax-free.

In short, IRAs have some excellent tax advantages over standard brokerage accounts. The trade-off is that you generally agree to leave your money in an IRA until you’re at least 59 ½ years old (with a few exceptions). While the IRA versus taxable brokerage account decision is a bit more complex than that, the tax differences and withdrawal flexibility are often the key deciding factors when choosing which type of brokerage account to open.

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