Definition and Examples of Taxable Events
A taxable event is an event or transaction that triggers a tax consequence. A taxable event often results in taxes owed, but some taxable events can also reduce your tax bill. Payment of wages, dividends, or interest, and the creation of capital gains are all common examples of taxable events. Some changes in tax filing status—such as from single to head of household, single to married filing jointly, or adding a dependent child—are also considered taxable events.
Receiving a paycheck from your employer, for example, causes you to owe federal taxes because wages are a form of taxable income. If you receive unemployment compensation, you will also be required to pay tax on it since it’s a form of taxable income. In addition, most forms of investment income are taxable, such as capital gains and income from retirement accounts like 401(k)s and pensions.
Some events can actually lower the amount of tax you owe. For example, you could benefit, tax-wise, as a result of getting married, having a child, or selling an investment at a loss. The amount of tax you owe as a result of a taxable event may also vary depending on what state you live in.
In addition to owing federal taxes, you may owe taxes at the state and local levels for taxable events.
How Does a Taxable Event Work?
The IRS determines the rules for the events and transactions affecting federal income tax liability for businesses and individuals, including taxable and nontaxable income, employee withholding, and capital gains taxes. Taxable events must be reported to the IRS and, in some cases, taxes may be automatically withheld. In addition, many states levy taxes on individual income.
When you receive wages from a W-2 job, for example, your take-home paycheck is reduced by the amount of state and federal taxes owed, according to how much you earn and the information you give your employer on Form W-4.
Buying something on which sales tax is due is also considered a taxable event.
Or let’s say you have money in an employer-sponsored 401(k) and you change jobs. You generally have a few options: Leave the money in the employer’s plan; roll it over to another tax-deferred account, such as the new employer’s 401(k) or an IRA; or cash out the money. In this situation, cashing out is a taxable event, generally requiring you to pay income tax on the account balance, plus an early withdrawal fee of 10% if you’re under age 59½. If you roll over or leave the balance alone, you can defer paying taxes until you withdraw the money.
Capital gains apply anytime you sell something for more than you acquired it for, such as art, collectibles, cars, stocks, bonds, and some real estate. The amount of tax you pay on capital gains depends on the type of asset and, in some cases, how long you have owned the asset.
For example, if you sell a stock for a profit that you have owned longer than one year, you’ll owe the long-term capital gains tax rate (up to 20%). For a stock that you’ve owned less than one year, the sale would be taxed as ordinary income (up to 37%).
Business income is not considered a capital gain.
How To Limit Events That Result in More Taxes
It’s to your financial benefit to limit or minimize taxable events that result in more taxes. Understanding the tax rules surrounding taxable events can help you reduce the amount of taxes you owe.
Hold Investments at Least One Year
One easy way to lower capital gains tax is by owning stocks for more than a year before selling them. Waiting to sell assets means you’ll qualify for the long-term capital gains tax rate, which is lower than the short-term rate.
Roll Over Old Retirement Plans
Roll over any 401(k)s into a new employer plan or an IRA. By doing so, you can delay paying taxes on the funds while letting the account balance grow in the meantime.
Use Losses To Offset Gains
Tax-loss harvesting is another strategy investors use to minimize taxes owed. Tax-loss harvesting involves strategically taking losses on assets, such as stocks, in order to offset the tax on current gains.
Use a Tax-Efficient Portfolio
In addition, tax diversification uses a balance of taxable, tax-deferred, and tax-free accounts to net the highest after-tax income.
Tax management can be complex and often varies by case. Therefore, it may be wise to talk with a financial advisor or tax professional about your particular situation.
- Taxable events are triggered by earning money or profits, selling assets, and changes in tax status.
- A taxable event often results in taxes owed, but some taxable events can also reduce your tax bill.
- While you can’t avoid taxes completely, you can strategize to reduce your overall tax bill.
- In addition to taxation at the federal level, state and local taxes may also contribute to the amount you owe for a taxable event.