What Taxes Do You Pay on Stock Gains?

Table of Contents

  1. What are the factors involved? 
  2. How will you know how much capital gains tax you owe?
  3. Calculating your Capital Gains Tax
  4. How to reduce your capital gains tax?
  5. Bear in mind your holding period


As thrilling as it may seem to invest in the stock market, figuring out the income tax on the stock market gains is not easy. When you trade stocks or assets, you incur either a loss or a profit. The profit you make by selling the stock, is termed as ‘capital gain’ and the loss you incur on selling the stock is termed as ‘capital loss’. And you only pay tax on your capital gains. 

The capital gains tax rates vary on factors like what kind of asset you’ve invested in, when you’ve earned your profit, how long you’ve held your assets, your total investment amount plus your overall income for the year. So, it becomes important to factor in the capital gains taxes when you are making investment decisions.


What are the factors involved?


Essentially, there are two ways you may be taxed on your stock gains. When you sell a stock or an asset at a price higher than its purchase value, the profit is taxed as a capital gains tax. In this case, the capital gains tax is calculated on the profit you’ve earned.

In the case where the companies issue dividends, you’d be taxed on the dividend income that you gain. This tax depends on the type of dividend that is issued to you. Ordinary dividends have the normal income tax rates. Although the Qualified dividends are taxed at lower capital gains tax rates, not exceeding 15%.

A dividend is considered as ‘qualified’ if it is issued by a U.S organization or a qualified international organization and if it is owned by the investor for a minimum of 60 days. 

The dividends paid by qualified retirement accounts such as IRA or 401K will not be taxed.

The capital gains are of two types. They are long-term and short-term gains. If you earn profit by selling the stock you’ve held for over a year, it’s considered a long-term gain. If it’s under a year old, it’s a short-term gain. The tax you pay for your long-term capital gains is lower than on short-term capital gains.



How will you know how much capital gains tax you owe?


The amount of tax you pay on your returns after selling a stock or other investment asset depends on several factors. The first thing you need to do before selling a stock is to determine if your gains are long-term or short-term. 

The capital gains tax rate on Short-term investment is equal to your regular income tax rate. However, the long-term capital gains are taxed at a rate, no more than 20%.

For example, if your regular income tax rate is 32%, your short-term capital gains tax rate would be 32%. And as of 2021, your long-term capital gains would be taxed at 20% of your income, if your earnings are over $445,850. Refer to the table below for more details. 

Calculating your Capital Gains Tax

The capital gains tax is levied only on the profit that you earn from selling your stock and not on the selling or buying price of the stock. To calculate your capital gains taxes, first, you need to find your ‘basis’ which is what you pay for your stock or asset plus commissions and reinvested dividends.

For example, if you bought stock worth $1000 about 5 years ago and you earned a sum of $100 dividends which you reinvested yearly, your total basis would be $1100. If you sell the stock for $1500 this year, then your net gain is calculated by subtracting the basis ($1100) from the selling price ($1500) which is equal to $400. Your capital gains tax is calculated on your net gain ($400).

So what happens when you hold a stock that you received as a gift or you inherited from a relative? Well, when you inherit the stock from a relative, the ‘basis’ is the fair market value of the stock on the date of transfer of ownership of the stocks (or the date of death of the previous owner). And when you receive the stock as a gift, the ‘basis’ would be either the fair market value on the date you were gifted or the original price the previous owner paid for the stock, whichever is lower.


How to reduce your capital gains tax?


When you pay commissions or brokerage to receive advisory services or manage your stock or mutual funds, those can be considered as deductible investment expenses. Report these deductions on Schedule A of your tax return to lower your payable capital gain tax and increase your gains.

You can further reduce your taxes by offsetting your capital gains with your capital losses. Here’s how it works. For example, if you were able to make a profit of $2000 on one stock in a year but you incurred a loss of $500 on selling another stock, your tax is calculated only on the net gain of $1500.

However, in the case where your losses exceed your gains, you could deduct the total losses from your investment profits up to $3000/ year. For example, if you run into a capital loss of $2000 and gain of $500, you could deduct $1500 for investment losses on your tax returns.

A word of caution: If you want to sell a stock at a loss to offset a gain to save on your taxes, the IRS will not allow you to claim a capital loss if you buy back the stock within 30 days. Hence, wait for a minimum of 30 days to repurchase the stock if you want to claim the capital loss.


Bear in mind your holding period



Note that only if you sell the stock after over a year of the purchase of the stock, it becomes eligible for ‘long-term capital gains tax’. Long-term capital gains can lower your tax liability. It's important to keep a track of how long you’ve held an asset or stock , because that helps you figure out the appropriate capital gains tax you owe. Figuring out your capital gains tax while buying and selling stock will help you make smart investment decisions.

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