Last Updated: August 31, 2021
Joining the stock market and exploring various trading possibilities is an exciting time for any potential investor, especially for a beginner.
Aside from that, the COVID-19 pandemic has left many with some extra time on their hands. And the more fortunate ones got some spare funds to invest, too. As a result, we now witness a flood of first-time traders.
Unfortunately, however, many who enter the market forget to account for paying taxes on stocks. Inevitably, this leads to disappointments.
Still, while the tax segment can indeed change your earning prospects, it’s not something to demotivate and turn you away from investing altogether. Instead, you could dedicate some time to your research and calculations to prepare better.
So, stay with us and learn more about:
- Capital gains taxes in general
- What are some more favorable investment options in terms of tax
- How you can avoid taxes on stock gains in some instances
Capital Gains Explained
First of all, what is capital gain?
This is the difference you get between the price at the moment you sell your capital asset and its value when you first bought it. Or, if you prefer formula, it is:
Selling price – Purchase price = Capital gain
Stocks, bonds, real estate, vehicles, jewelry, and collectibles all fall under the capital assets category. Excluded from this list and, therefore, taxation are:
- Different kinds of artistic compositions (literary, musical, etc.)
- A letter, a memorandum, photography, or similar property
- Patents and inventions
Notably, you realize a capital gain and pay taxes on it only after you sell the asset in question.
Until that moment, your holding is unrealized gain, and it doesn’t undergo taxation.
Capital gain is the base for capital taxation. And for that matter, we classify it as a short-term capital gain or a long-term capital gain.
Short-term capital gains
These are the gains on assets you’ve had in your possession for under a year. The taxes for short-term capital gains are usually less favorable. Most often, the taxation happens at your regular income tax rate, within your tax bracket. So, the taxes can go up to 37% of your total gain.
There are some exceptions to this one-year holding duration rule, but they are not so common.
Long-term capital gains
Every time you sell an asset that has been in your possession for longer than a year, it’s considered a long-term capital gain.
The US tax system favors long-term investors since they contribute to the national economy in the long run. As opposed to fast-buying-fast-selling investors that only achieve personal gain.
In light of this, the long-term capital gains tax rate is usually more investor-friendly. It varies from 0% to 20%, depending on the taxable income.
Most investors in the US report a long-term capital gains tax that is 15% or lower.
How Are Capital Gains Taxed?
So, capital gains are taxed according to different capital gains tax rates within the individual tax brackets.
Remember, only once your capital gain is realized, you’re obliged to pay taxes, not before that.
For example, if you have bought a house for $300,000 that is now worth $350,000, your capital gain is $50,000. However, not until you sell the property, you’ll need to pay the tax on the capital gain.
In the meantime, the value of the house may change further. But the taxable capital gain is the one you make at the moment of sale.
Federal capital gains tax
As of 2021, there are three different long-term capital gains tax brackets.
- The highest tax rate of 20% is for earnings of over $441,451 for single taxpayers and over $496,600 for married joint filers.
- Most taxpayers fall within the middle tax bracket. The tax rate here is 15% for singles with more than $40,00 but less than $441,450 in earnings. In the case of married couples, joint earnings should be between $80,001 and $496,600.
- Single taxpayers that earn less than $40,000 and married couples earning jointly up to $80,000 mostly pay nothing or 0% tax on long-term capital gains.
In the meantime, there are seven short-term capital gains tax brackets that correspond with the usual income tax brackets (10% to 37%).
All seven US capital gains tax brackets depend on the investors’ income figures.
Capital gains tax by state
Aside from these federal tax requirements, numerous states charge state-level taxes on capital gains as well. These taxes can significantly vary from state to state.
And so, the state tax on your capital gains depends on your ZIP code.
The following are the states that apply no income tax, to begin with, and so they don’t have capital gains taxes either:
- New Hampshire
- South Dakota
In addition, in Colorado, Nevada, and New Mexico, you don’t pay capital gain tax, although the regular income tax exists.
Meanwhile, the states with the highest capital gains tax rates are:
- New Jersey
- Oregon, and
Capital gains tax by assets
In case you were wondering:
What is the capital gains tax rate for a specific asset category?
Here is how it works:
While taxes on your regular income can be 10%, 12%, 22%, 24%, 32%, 35%, or 37%, long-term capital gains taxes usually have lower rates.
Also, some tax groups don’t depend on assets’ holding period or your ordinary income tax bracket.
Finally, when it comes to real estate, taxation depends on its intent basis. And so, your principal residence capital gain will be taxed differently from your trading real estate capital gain.
But, let’s look at some of these groups in more detail.
Collectibles capital gains
Your collectibles include but are not limited to:
- Different art pieces
- Antiques and old coins
- Precious metals and gems
- Stamp collections, banknotes, and similar
You owe 28% tax on capital gains after the sale of such objects. And again, your income doesn’t make any difference here. This rate is standard.
Real estate capital gains
Capital gain expenses on your residential property are usually less than those on your investment real estate.
This is mainly due to several principal residence tax benefits that every home seller has the right to enjoy.
For a start, the law states that every time a person sells their principal residence, the first $250,000 is not subject to taxes on capital gains. This figure goes up to $500,000 for married couples filing jointly.
So let’s say you and your spouse have bought a family house for $500,000 and sold it for $1.2 million. Your profit, in this case, is $700,000, but you’re required to pay tax only on $200,000 as the rest is tax-deductible.
This rule only applies if you have lived in the property for two years, at least. And the property has to be in your possession for longer than five years altogether.
Also, you can add any major improvement costs they had to the original home purchase price. This way, you’re reducing the difference between the base cost and sale cost — or the taxable gains.
Let’s now calculate capital gains tax with a new example.
Supposedly, you have bought your house for $250,000, and three years later, you sell it for $550,000. Your profit from the sale is $300,000. However, in the meantime, you’ve invested $50,000 on the necessary plumbing installations.
Since you’ve paid $50,000 for the house reparations, you can deduct that amount from your profit. You can add this figure to your initial home price instead.
So your actual profit is $250,000. And since that is the exact amount of your tax deduction after your home sale, you’re not required to pay any tax on capital gains.
Investment real estate capital gains
Profit tax on investment real estate can vary from 0% to 20% for long-term investments and from 10% to 37% for short-term ones — like the regular income tax.
However, once you claim the real estate depreciation, the amount is taxed at 25%.
Furthermore, some taxpayers are subject to the additional 3.8% of tax on capital gains if their MAGI exceeds:
- $125,000 for single taxpayers and married ones filing separately
- $200,000 for a surviving spouse
- $250,000 for married couples filing jointly
MAGI is the modified adjusted gross income on which many additional benefits, such as a health insurance plan or opening of a Roth IRA account, depend.
Paying Taxes on Stocks — How Are Stocks Taxed?
Stocks get taxed on the same basis as any other financial asset that brings gain.
So, you don’t pay tax on the stock’s purchase value, but on the profit it generates.
But, how to calculate stock profit?
You get the stock profit figure by calculating the difference between the initial and the final value of the stock and turning it into a percentage.
For example, let’s say you invest $2,000 in one hundred shares, $20 a stock. If a couple of months later, the stock value rises to $25, the total worth of your stocks would be $2,500. Your profit then is $500, or 25%.
But just because your stocks have risen in value, it doesn’t mean that you’re to pay any tax immediately.
When do you pay taxes on stocks exactly?
Similarly to paying taxes to any other realized capital gains, one is obligated to pay taxes only once they sell the stocks.
Luckily, most online brokerages will help you keep track of your due payments. So you don’t need to keep in mind all the dates and numbers constantly.
Additionally, you can use any of the excellent tax software programs to help you file taxes on stocks.
Short vs long term stock gain tax
When it comes to investing in equities, long-term investments are the most favorable ones.
This is because the tax rate for stock gains mostly depends on the time span of your investment and not exactly on the stock type.
But how much tax do you pay on stocks, precisely?
This depends on whether you’ve had those stocks in possession longer than a year or not. While the maximum tax for long-term stock doesn’t exceed 20%, the assets you’ve kept for less than a year can be taxed up to 37%. The exact rate, again, depends on the ordinary capital gains tax brackets.
Are dividends taxable?
Some shareholders prefer dividend-paying stocks and mutual funds since they can have higher ROI (return on investment). Dividend-payment stock ROI comprises the dividend yield and any profit that the shares generate.
Dividends are taxable too. However, their taxes slightly differ from taxes on stocks sold.
What determines the tax rate for dividends is whether they are qualified or nonqualified.
- Qualified dividends undergo taxation on the long-term capital gains basis. These are usually dividends from US companies’ stocks.
- Nonqualified dividends undergo taxation on the regular income basis. Here, we are mostly talking about real estate investment trusts (REITs).
Tax-loss harvesting — a way to offset the stock gain tax
A good thing about stock taxation is that you can use your stock capital losses to offset gains.
For example, if you’ve sold some shares and gained $15,000 this year and sold the others at a $5,000 loss, you’ll be taxed on $10,000 capital gains.
For that reason, many shareholders sell shares that are at a loss once realizing they might have to pay too big taxes on gains. This strategy, called tax-loss harvesting, can significantly help in balancing current capital gains taxes.
Also, whenever your losses exceed your gains, you can state that on your tax return and deduct the difference from your tax (the maximum is $3,000 a year).
How to Avoid Capital Gains Tax on Stocks
In case you caught yourself contemplating on the thought of:
How to avoid capital gains tax on stocks?
Tax evasion, of course, is not an option.
Luckily, aside from tax-loss harvesting, there are many other constructive and legal ways to avoid taxes on some of your stock. Or, at least, to reduce them.
Here are some of the ideas on how to make paying taxes on stocks more cost-effective.
To avoid capital gains tax, whenever possible, turn your short-term investments into long-term ones. But, of course, this is not always perfectly achievable since the market is volatile.
Nonetheless, it’s crucial to have some patience. Try not to sell your holding at every sign of potential company decline.
Make use of the annual gift tax exclusion
Some people give stocks to their family members to utilize the gift tax exemption right.
Namely, each US citizen can transfer an investment of up to $15,000 to another person without paying tax on it. These investments can be in the form of money, shares, or any other asset type. Paying taxes on inherited stocks works the same.
The $15,000 annual exclusion is per receiver, not per contributor. Meaning, you can give $15,000 to as many people as you wish to. As long as your gift doesn’t exceed this amount for any individual, it’s not taxable.
Of course, once your gift makes a further gain in the new owner’s hands, it becomes taxable again.
Use dividends payments to rebalance
Some investors rebalance their portfolios by selling equities that have raised in value. After which, they use these capital gains on stocks that are thriving to support the downgrading ones.
However, you should probably know that using dividend yields to invest in underperforming assets can bring better results.
Like this, you are postponing the sale of strong performers. And with that, you are avoiding large taxes on these high realized capital gains.
Carry losses over to reduce capital gains tax on stocks for the next year
Another useful benefit that many stockholders oversee is that the net capital losses are transferable to next year.
So, if your net capital losses exceed the limit you can deduct for the time being, you can carry the excess into the following year. So, whatever excess loss you have that exceeds the limit of $3,000, you can still deduct it in the future.
Why not use the opportunity to reduce future taxes?
Consider opening a tax-advantaged account
Did you know that many personal accounts, if not entirely bypassing paying taxes on stock gains, offer considerable tax advantages?
Some of them, like individual retirement accounts (IRAs), 529 college savings accounts, and 401(k) plans, even allow the investments to grow tax-free. With these accounts, you don’t have to pay tax on stock earnings every time you sell assets.
Roth IRAs and 529s are particularly convenient since they don’t have any taxes on investment earnings.
By choosing traditional IRAs and 401(k)s, you’ll pay some taxes, but only at your gain deliveries in retirement.
Make use of a robo-advisor
Getting a robo-advisor can help you save a lot on tax. It’s almost like having a human advisor, only cheaper and with more precise algorithm-driven financial operations.
Robo-advisors can automatically allocate your funds to maximize your gain. And they often use smart-tax strategies to minimize capital gains tax on stocks.
Tax-loss harvesting is a common strategy with most robo-advisors.
So, do you pay taxes on stocks?
You don’t actually pay taxes on having stocks. But, you do pay taxes on each occasion your investment brings a realized capital gain.
Here’s a brief rundown of the things you need to keep in mind regarding paying taxes on stocks:
- Short-term capital gains taxes are usually significantly higher than long-term ones. So, whenever you can, try investing for longer periods.
- Dividends are also taxable. They have a different way of taxation according to their type. If you’re buying stocks that pay dividends, examine their exact tax rates. The same goes for tax options.
- There are numerous legal ways to reduce or avoid capital gain taxes on your stocks. Whenever applicable, you should employ them.
Stock options are taxed according to their type and according to the holding period. Therefore, the exact rates may differ from company to company, so better confirm these with your financial advisor.
Stock options are taxed once they are realized. That means, as soon as you sell your stocks that have generated capital gain, you are obligated to pay taxes.
No, you don’t pay taxes on stocks you don’t sell. You only pay taxes on realized gains.
No, you don’t pay tax on unrealized gains.
Whether you reinvest capital gains or not once you realize a profit, paying taxes on stocks is mandatory. Although reinvesting capital gains to avoid tax may seem like a plausible option, the IRS marks capital gains as soon as they happen.
IRA, 401(k), and similar tax-favored retirement accounts are the only exceptions here. With them, you can sell and reinvest without immediate tax charges. Only once you withdraw from these accounts, the tax-payments will come into the picture.