Many stockholders don’t understand how the IRS charges taxes on equity investments. Some people think that the IRS charges a tax on profits that you have made on any shares of stock that you owned during the year. That is a common misconception. The IRS charges taxes on dividends that you received and any profits that you made on shares of stock that you have actually sold. The latter is known as a capital gains tax.
What Should you Know About the Capital Gains Tax?
Every investor who makes a profit after selling a share of stock must report the proceeds to the IRS at the end of the year. Here are some of the factors that you need to keep in mind when dealing with capital gains.
The Entire Capital Gains Tax is Reported in the Year of the Sale
You may have purchased a share of stock in 2010 and sold it in 2012. The value of the stock may have increased by $10 during 2011 and another $10 in 2012. You will pay the $20 tax that you accrued during 2012.
Capital Gains Taxes Vary Depending on the Time you Held the Investment
The IRS charges a different tax rate for long and short-term investments. Any investment held over a year is going to be considered long-term. You may want to hold an investment a little longer if you are planning to sell it after holding it for a year. That would mean that you would only need to pay a lower tax rate.
The IRS states that you don’t have to pay a long-term capital gains tax at all if you are in the 10-15% tax bracket. You will only need to pay 15% on your returns if you are in the 25% tax bracket.
Of course, you don’t want to hold your stocks longer if you fear that they will be dropping and won’t recover in the long-term. You should always be more focused on making a profit on your investments than reducing your taxes.
Remember to Write Off Capital Losses
The IRS allows you to deduct any losses that you incurred after selling your stocks. Make sure that you don’t forget to do so. Substantial losses could even place you in a lower tax bracket and reduce the rest of your income tax.
Some financial advisors suggest that you sell some of your stocks at a loss at the end of the year to offset some of your gains during tax season. I don’t think this is usually practical advice, but it may be a good idea if you are skeptical that the stock will recover at all. You may want to cut your losses and write them off if your other capital gains place you in a higher tax bracket.
Capital gains taxes can consume a large chunk of your profits. You should do everything that you can to reduce your taxes as much as possible. The best way to do so is to hold your stocks for over a year so the IRS will classify them as long-term investments.
About the Author: Kalen holds an MBA in finance from Clark University in Worcester, MA. He currently works as a financial writer where he talks about the benefits of pursuing an llm in tax management.