There's a lot to learn for new investors, such as how to choose, open, and use a brokerage account. But one part of investing that's often overlooked by beginning investors -- and even some experienced ones -- is how investing and taxes work.
Knowing which investments are taxed (and, perhaps more importantly, which are not taxed) is important. How you navigate the intersection of investing and taxes can dictate your ability to profit from your investments. Here's a primer on the basics of investing and taxes to help you get started.
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. 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.
The profit you make when you sell a purchased asset is called a capital gain. For investing and taxes, capital gains generally occur 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 taxes.
Capital gains taxes apply if you profit from the sale of a range of investment types, including bonds, mutual funds, ETFs, precious metals, cryptocurrencies, and collectibles. Even real estate sold at a profit can be considered a capital gain for investing and taxes, though the rules are a bit more complicated. (The calculation of a capital gain in real estate usually depends on whether the property is your personal residence.)
The IRS classifies capital gains into two main categories for investing and taxes: long-term capital gains and short-term capital gains. Long-term capital gains occur when you sell an asset you've owned for longer than a year. Short-term capital gains occur when you sell an asset you've owned for a year or less.
For example, if you bought a stock on Jan. 1, 2019 and sold it on Jan. 2, 2020, 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, 2019 and sold it on Jan. 1, 2020, you didn't own it for longer than a year, so it's a short-term gain.
As you'll see in the next couple sections, long- and short-term capital gains are treated differently when it comes to investing and taxes.
The long-term capital gains that occur when you profit from selling an investment you've held for over a year are 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 2021 tax year (the tax return you'll file in 2022):
|Long-Term Capital Gains Tax Rate||Single Filers (taxable income)||Married Filing Jointly||Heads of Household||Married Filing Separately|
|0%||$0 - $40,400||$0 - $80,800||$0 - $54,100||$0 - $40,400|
|15%||$40,400 - $445,850||$80,800 - $501,600||$54,100 - $473,750||$40,400 - $250,800|
|20%||Over $445,850||Over $501,600||Over $473,750||Over $250,800|
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 are examples of income that counts toward your net investment income for the purposes of investing and taxes.
As with most things in 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 assessed the additional tax. For single filers, the threshold for the additional tax is an adjusted gross income of $200,000.
When it comes to investing and taxes based on net income, only the portion 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 is liable for the 3.8% tax.
One reason it's important to learn about investing and taxes is that while long-term capital gains receive favorable tax treatment, 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 that, in nearly all cases, short-term gains are taxed at a higher rate than long-term gains.
For reference, here are the 2021 U.S. tax brackets which apply to short-term capital gains:
|Marginal Tax Rate||Single||Married Filing Jointly||Head of Household||Married Filing Separately|
|10%||$0 - $9,950||$0 - $19,900||$0 - $14,200||$0 - $9,950|
|12%||$9,950 - $40,525||$19,900 - $81,050||$14,200 - $54,200||$9,950 - $40,525|
|22%||$40,925 - $86,375||$81,050 - $172,750||$54,200 - $86,350||$40,925 - $86,375|
|24%||$86,375 - $164,925||$172,750 - $329,850||$86,350 - $164,900||$86,375 - $164,925|
|32%||$164,925 - $209,425||$329,850 - $418,850||$164,900 - $209,400||$164,925 - $209,425|
|35%||$209,425 - $523,600||$418,850 - $628,300||$209,400 - $523,600||$209,425 - $314,150|
|37%||Over $523,600||Over $628,300||Over $523,600||Over $314,150|
Sometimes, you may not have any gains when you sell investments. In some cases, you may even find yourself with capital losses.
Here's how this works for the purposes of investing and taxes: 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. Conversely, you have to use short-term losses to reduce short-term gains before using them to reduce any long-term gains.
In the event that 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.
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 like 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, on the other hand, are taxed as, well, ordinary income.
To be considered a qualified dividend, two basic requirements must be met:
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.
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 fixed-income investments (bonds) you own, as well as any interest your brokerage pays on cash balances in your account.
One big exception is municipal bonds. Generally speaking, the interest paid by municipal bonds is exempt from taxation.
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, an IRA account is not subject to capital gains taxes on the sale of profitable investments or taxes on dividends received. Additionally, you don't need to report interest income you receive in your IRA.
With a traditional IRA, your contributions to the account may be tax-deductible. Plus, 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 usually 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 this overview allows, the tax differences -- and withdrawal flexibility -- are often key deciding factors when choosing which type of brokerage account to open. This is just one of the ways in which learning about investing and taxes is part of a successful investment strategy.
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