Taxes on stocks can be very complex. This is primarily due to some of the terminology and variables that distract the investor or trader from understanding the system. However, if you take the time to become aware of and knowledgeable about how stock gains and losses are taxed, you will benefit financially.
To begin with, the IRS (Internal Revenue Service) taxes capital gains and deducts capital losses from your gains. Capital gains and losses are the profits or losses resulting from the sale of securities (stocks in this case).
Therefore, if you sold shares for a total of a $100 profit, it would be considered a capital gain. However, if you also had a loss of $50 (capital loss) on another set of shares you would only be taxed on the overall $50 gain. Thus, you subtract your $50 loss from the $100 gain in order to result in a $50 capital gain.
You must also note that the IRS will only calculate realized gains and losses for the year, not unrealized. In this case, “realized” simply refers to the fact that you have sold your shares, while unrealized means you may have incurred a gain or a loss but your shares have not been sold yet.
Now you’re most likely wondering what rate your gains will be taxed at. In order to differentiate between true investors and traders, the government taxes them at different rates based on the length of their ownership of the stock.
Thus if you hold your stock for less than a year (365 days), it is calculated as a short-term gain or loss. On the other hand, if you hold your stock for more than a year, it is calculated as a long-term gain or loss. Long-term gains are taxed at a more favorable rate (usually 15%) if you fall in or above the 25% tax bracket. If you fall at below the 15% tax bracket, you will be taxed at 5%.
Short term gains are taxed at a less advantageous rate, depending on your tax bracket. You will receive no benefit for short-term gains and will be taxed at the same rate of the tax bracket you fall within. If you have an overall capital loss for the year, you have the ability to use the remaining short-term loss to “shield” a maximum of $3,000 of standard income. This means that you get to avoid paying taxes on $3,000 of the income you earn from your career.
This is merely a small portion of the information that is essential to understand. However, do not take it for granted. These basics are absolutely vital in understanding how your gains and losses are taxed and how to benefit from the system. For instance, it is obviously more beneficial for one to maintain your stocks for at least one year (plus a day to ensure the tax benefit). Yet, if you fall at or below the 15%, the short-term gain tax burden may not affect you as severely.
Edward Hughes wrote this article for Tax Matters Solutions, a Fort Wayne, Indiana business helping people with IRS problems.