Investing and Taxes: What Beginners Need to Know

There's a lot for new investors to learn, such as how to choose and open a brokerage account. But one thing often overlooked by beginning investors -- and even some experienced ones -- is how investing and taxes work.

Knowing which investments are taxed (and which are not) is important. How you navigate the intersection of investing and taxes matters, as it can change your profits. Here's a primer on the basics to help you get started.

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

Here's the first thing you should know about investing and taxes as a new investor: If you own a stock and the price goes up, you don't have to pay any taxes.

In the United States, you only pay taxes on investments that increase in value if you sell them. In other words,the government taxes your profits, not your holdings.

Consider this: Warren Buffett owns more than $100 billion in Berkshire Hathaway stock, and he's never paid a dime in taxes on any of his shares. How? Because he's never sold them.

The profit you make when you sell an asset is called a capital gain. Capital gain happens when you buy a stock or other investment at one price and later sell it at a higher price.

For example, if you buy stock for $2,000 and sell it for $2,500, you have a $500 capital gain. That gain is subject to federal taxes.

Capital gains taxes apply if you profit from the sale of most investment types. These include bonds, mutual funds, ETFs, precious metals, cryptocurrencies, and collectibles. Even real estate sold at a profit can be considered a capital gain, though the rules are a bit more complicated.

The IRS splits capital gains into two main categories: long term and short term.

• Long-term capital gain: You sell and profit from an investment you've owned for longer than a year.
• Short-term capital gain: You sell and profit from an investment you've owned for a year or less.

For example, if you bought a stock on Jan. 1, 2020 and sold it on Jan. 2, 2021, you owned it for more than a year. Any resulting profit is taxed as a long-term capital gain. On the other hand, if you bought a stock on Jan. 1, 2020 and sold it on Jan. 1, 2021, you owned it for less than a year, so it's taxed as a short-term gain.

As you'll see in the next couple sections, long- and short-term capital gains are taxed differently.

READ MORE: Best Stock Brokers for Beginners

Long-term capital gains tax rates

Profit from selling an investment you've held for over a year is taxed according to the IRS' long-term capital gains tax rates. Those rates are 0%, 15%, or 20%, depending on your total taxable income.

Here's a quick look at the long-term capital gains tax rates for the 2023 tax year (the tax return you'll file in 2024):

In addition to the rates listed in the table, higher-income taxpayers may also 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 counts toward your net investment income.

As with most things investing and taxes, the taxable limit depends on your filing status. If you are a married couple filing jointly with adjusted gross income of more than $250,000, your investment income above that threshold is taxed. If you're married and file separately, the threshold drops to $125,000. For single, unmarried, or head-of-household filers, the threshold for the additional tax is an adjusted gross income of $200,000.

Only income above the threshold is subject to the net investment income tax. For example, if you and your spouse earn $200,000 from your jobs and $70,000 from your investments, only the $20,000 that makes your income exceed the threshold may be taxed at 3.8%.

Short-term capital gains tax rates

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

This means short-term gains are typically taxed at a higher rate than long-term gains.

For reference, here are the 2023 U.S. tax brackets that apply to short-term capital gains:

What if your capital gains are negative?

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

You can use capital losses 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 is $4,000.

You must use long-term capital losses to offset long-term gains before applying them toward short-term capital gains. Similarly, you must use short-term losses to reduce short-term before long-term gains.

If your capital losses are greater than your capital gains in a given year, you can use them to offset your other taxable income. This deduction is capped at $3,000 per tax year (or $1,500 if married and filing separately). However, if your net capital losses exceed the capped amount, you can carry them over to subsequent years.

Dividend taxes: When you receive shareholder profits

Capital gains and losses aren't the only important part of investing and taxes. Dividends (earnings distributed by companies to shareholders) are also taxed, at a rate depending on the classification.

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

To be considered a qualified dividend, two basic requirements must be met:

1. The company that paid the dividend must be a U.S. corporation or a qualified foreign corporation, which generally means the stock is traded on U.S. exchanges.
2. 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 of 90 days out of the 181-day window beginning 90 days before the ex-dividend date.)

Some dividends are never considered "qualified." These include dividends from tax-exempt organizations, capital gains distributions, dividends paid on bank deposits (for example, 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 ordinary dividends, although there are exceptions.

Interest income: When you earn interest on cash or bonds

The final type of income to note for investing and taxes is interest income, which is typically taxed as ordinary income. This includes interest payments you receive on bonds, ETFs, mutual funds, checking and savings accounts, and certificates of deposit (CDs). If your brokerage pays you interest on cash balances, this, too, is taxed as ordinary income.

One big exception is municipal bonds, which are bonds issued by states, cities, and localities. Generally speaking, municipal bond interest is not taxed by the federal government.

IRAs are exempt from most investment taxes

An important distinction to make regarding investing and taxes is the difference between a standard (taxable) brokerage account and an individual retirement account, or IRA.

The rules for investing and taxes we've laid out here only apply to investments held in a taxable brokerage account. IRAs allow you to invest on a tax-deferred basis.

In other words, you don't pay capital gains taxes on the sale of profitable investments or on dividends received through an IRA. Additionally, you don't need to report interest income you receive in your IRA.

There are two kinds of individual retirement accounts: traditional and Roth.

• Traditional IRA: Pay taxes when you withdraw money from the account.
• Roth IRA: Pay taxes when you contribute money to the account.

When choosing between the two, consider tax advantages and withdrawal flexibility. That'll help you decide which account may save you more money over the long run.

All IRAs have some excellent tax advantages over standard brokerage accounts. The trade-off is that you usually leave your money in an IRA until you're at least 59½ years old (with a few exceptions).

Related reads:

• How to Open a Brokerage Account
• Complete Guide to Taxes
• How 401(k)s Are Taxed
• How Capital Gains Are Taxed
• How Cryptocurrency Is Taxed
• How to Calculate Property Taxes