I am sure you have all heard the phrase “...nothing is certain except death and taxes.” When it comes to taxes, investment returns are no exception (except in a Roth IRA). Learning about taxes for the early investor can be difficult to understand. The purpose of this post is to highlight the key points you need to know about taxes and investments, and some important things to keep in mind:
Taxes come into play in two different scenarios when it involves investments.
One scenario is when you receive income from your investments.
Income from investments:
Income from your investments can be generated in numerous ways. The two most common are from dividends and interest. Income generated through interest is typically taxed at your ordinary income tax rate.
For stocks, a typical income investors have is from dividends. Dividends can also be taxed at an ordinary income tax rate but not always. There are some dividends that can qualify to be taxed at a lower long-term capital gains tax rate. In order to find out if your stock’s dividends qualify to be taxed at a long-term capital gains tax rate you can contact your broker and they will be able to provide that information to you.
The other scenario is the gains or loses from your investment sales.
When you sell an investment, usually either of the three things happen - you make money, you lose money, or you break even. When you make money this is referred to as a capital gain. Capital gains are almost always taxed - unless the investment is within an IRA.
Within capital gains, there are two different types. Short term capital gains and long term capital gains - depending on which capital gain type your investment sale falls into, will determine how the capital gain is taxed.
Short Term Capital Gains
To consider your capital gain as a short term capital gain, the buying and selling of an asset must occur in one year or less. For example, if you bought a stock for $20 in January 2021 and sold that same stock for $25 in September 2021, that would be considered a short term capital gain. The $5 that you made from buying and selling the stock is the short term capital gain that will be taxed. The tax rate of a short term capital gain depends on your income (Short term capital gains is also taxed as ordinary income). The chart below will show you what tax bracket you fall under for a short term capital gain:
Short Term Capital Gains Tax Rates:
This can be quite confusing for those of you who are just starting to research about investment taxes. Hopefully the following example will help you to fully understand and tie this all together.
Short term Capital Gain Example:
Long Term Capital Gains
For the purpose of simplifying this example, we will be excluding tax deductions.
As mentioned above, the other type of capital gain is a Long Term Capital gain. To consider your capital gain a long term capital gain, the asset must be bought and held for more than 12 months before it is sold. For example, if I bought a stock in February 2020 for $30 and in April 2021, sold that stock for $40 - this would be considered a long term capital gain. Almost always, long term capital gains are taxed at a lower rate than short term capital gains. The tax rate for long term capital gains are also dependent on your income. The chart below will show you what tax rate you fall under for a long term capital gain:
Long Term Capital Gains Tax Rates:
Long Term Capital Gain Example:
The difference between the long term capital gain example and the short term capital gain example, is a whopping $2,489.
In this case, having patience definitely pays off when it comes to paying taxes. Although it is not explicitly stated in your profit/loss metric, holding your investments for more than a year has the potential to result in higher overall profits due to paying less in taxes.
It's important to take tax into consideration for any investor - although they may appear invisible initially, taxes will almost always make an appearance.