It is important to keep taxes in mind when investing in the stock market. If you don't consider the tax consequences of your stock investments, you could end up with much less than you planned.
There are two tax environments for investing in stocks: qualified retirement accounts and regular accounts. You will most likely have some investments in both environments.
Taxes on Retirement Accounts
Retirement accounts, such as a 401(k) or an Individual Retirement Account (IRA), generally allow your money to grow tax-deferred until withdrawal. Money that you contribute to these plans is deducted from your taxable income, which lowers your current tax bill. In a 401(k), you typically invest in mutual funds rather than individual stocks. With IRAs, you can invest individual stocks, mutual funds, bonds, and other investments.
When you withdraw money from a 401(k) or traditional IRA after age 59 1/2, you pay regular income taxes on your contributions and any earnings. If you withdraw the funds before you turn 59 1/2, you typically pay a 10% early withdrawal penalty in addition to regular income taxes.
A Roth IRA allows you to invest after-tax dollars. It does not lower your current tax bill, but you can withdraw contributions and earnings tax-free during retirement. You don't pay a penalty on contributions you withdraw before age 59 1/2.
If you believe you will be in a lower tax bracket during retirement, you may be better off with a regular retirement account. If you think you will be in a higher tax bracket during retirement, you should consider a Roth account. You could also invest in multiple types of plans.
There are certain restrictions on regular and Roth retirement accounts, so consult your tax advisor before deciding on the best option for you.
Taxes on Stocks
Stocks outside retirement accounts have two types of taxes. If your stock pays dividends, you must pay income taxes on the payments. The taxes on dividends depend on whether the dividend is qualified. Qualified dividends are taxed at the capital gains rate, which varies depending on your modified adjusted gross income (AGI) and taxable income. Your Form 1099-DIV will indicate whether your dividend was qualified. Non-qualified dividends are taxed at your ordinary income tax rate.
The other tax consideration involves selling the stock for a profit or loss. If you hold the stock for more than one year, any gain is taxed at long-term capital gains rates. The long-term capital gain tax rates are 0%, 15%, or 20% depending on your income and other factors.
If you sell a stock for a profit but have owned the stock for less than one year, you will pay regular income taxes on the gain. Depending on your tax bracket, this could be significantly higher than 15%. The current federal tax rates range from 10% to 37% depending on your income. Typically, it's better to hold your stocks and sell them after you've reached the one-year mark, but as always, check with your tax advisor.
What if you sell for a loss? In many cases, you can claim a long or short-term capital loss. These losses can often be used to offset capital gains. You can deduct $3,000 of capital losses. Any losses beyond $3,000 can be carried over into future years.
It is important to consider the tax consequences of your stock investments. Generally, the more you can put into a qualified retirement account, the better it is from a tax point of view.
However, your stock investments are only one piece of your tax situation. A qualified tax advisor can help you decide the best strategy.
- Retirement accounts allow your funds to grow tax-deferred.
- When you withdraw funds from a traditional IRA or 401(k) after age 59 1/2, you pay income taxes.
- You do not pay income taxes on qualified withdrawals from a Roth IRA.
- With individual stocks, you're taxed on dividends and any gains realized after you sell the stock. The tax amount varies based on how long you've owned the stock and your income.