Investments and How They’re Taxed
One of the smartest things you can do is let your money work for you. No doubt you’ve heard that advice before. With interest rates as low as they are and have been for some time, letting your money sit in a savings account or even a CD currently amounts to little more than stuffing it in the mattress. If you really want to get a reasonable return on your money – that is, letting your money do some work – you’ll have to invest it.
Yes, investing carries risk, and market drops can lead to a decline in your principal; however, with risk comes reward, and capital gains and dividends typically will pay off better in the long run. It’s also important to understand how these investments are taxed.
Very simply, a capital gain occurs when you sell something for more than you paid for it. These gains aren’t limited to stocks. Hopefully, you’ll incur a capital gain when you sell property, either real estate or other property that may increase in value such as antiques, artwork, cars, and other collectibles. In order to calculate a capital gain, you must first know the basis for the item. The basis includes the amount you paid for an asset as well as other costs you paid in order to acquire it. Depending on the asset, those costs may include things like sales taxes, excise taxes, fees, and/or shipping costs.
A capital gain is not realized (and therefore not taxable) until you sell the asset. “Unrealized” capital gains and losses occur every day. For example, if you bought stock in XYZ Company for $1000 and the market rises, increasing its value to $1200, you have an unrealized gain of $200. You don’t have a capital gain until you actually sell the asset. Unrealized capital gains and losses affect your portfolio but not your tax return.
There are also long- and short-term capital gains, and those classifications are driven by the length of time for which you hold an asset. If you sell an asset that you’ve owned for a year or less, any profit from that sale is a short-term capital gain. Gains realized on assets that you sell after owning them for longer than one year are long-term gains. The long- and short-term differentiator comes into play at tax time. Short-term gains are taxed at a much higher rate than long-term gains, and that tax rate can be 10 to 20 percent higher. Depending on your tax bracket and income (i.e. the lowest brackets), you may not have to pay any tax on a long-term capital gain.
A dividend is a payment made to shareholders by a corporation. That payment may be in the form of cash or additional stock shares. Not all companies pay dividends, and those that do can set their own payout schedules (e.g. quarterly, annually, etc.) and formats (cash or additional shares). You might think of a dividend as a reward for owning stock in a corporation, and corporations may use dividend payouts as a way to attract more investors.
Companies can also change their dividend policies at any time. Dividend payouts typically reflect the profitability of a company. Start-ups and growth-oriented companies may re-invest their profits back into the company rather than paying dividends. That doesn’t necessarily make those companies bad investments. Re-investing for growth may very likely drive the value of the stock up, so you might not get a dividend but will rather see a greater capital gain.
For tax purposes, dividends are classified as ordinary or qualified. Like interest, ordinary dividends are taxed as regular income. Qualified dividends are taxes at a lower rate that ranges from zero to 20 percent. There are several criteria a dividend must meet in order to be classified as “qualified.” According to the IRS, “The payer of the dividend is required to correctly identify each type and amount of dividend for you when reporting them on your Form 1099-DIV for tax purposes.”
While you want to let your money work for you through investing, you’ll also want to keep an eye on the tax implications of investment proceeds. Currently, the tax rates for long-term capital gains and qualified dividends are the most favorable.
For 2016, the tax rate on long-term capital gains and qualified dividends is zero for those whose tax rate on ordinary income is up to 15 percent. For those whose ordinary tax rate is 25 to 35 percent, they will pay a 15 percent tax on long-term capital gains and qualified dividends. Finally, those paying the highest tax rate (39.6 percent) will only pay 20 percent on long-term gains and qualified dividends.
If you happen to incur a capital loss (i.e. selling an asset for less than you paid for it), you can subtract the loss from any incurred gains up to an annual limit of $3,000 ($1,500 if married, filing separately). If you loss exceeds $3,000, you can carry the unused portion of the realized loss in future tax years.
Capital gains and dividends are integral components in successful investing. At Waddy, we’re here to help you make the most of your money by leveraging the investments with the most favorable tax rates. Contact usto set up an appointment.