How Selling Stocks Affects Your Taxes
As an investor, if you sell a stock and profit from the sale, the length of time that you have owned it matters as you'll need to pay taxes on stock sales. Selling a stock that you’ve held for one year or longer, and made a profit, you will have to pay a long-term capital gains tax. However, if you sold a stock owned for one year or less, and profited, then you will pay a short-term gains tax rate.
Read on to learn more about taxes on stocks.
Taxes on stocks: Capital gains tax and dividends
While an investor can determine the length of time they’ve held their investment to determine if it's a short-term or long-term capital gains, it's also important to understand how are stocks taxed as there is taxation on stocks sales. Investors will also need to calculate their profits to help determine the amount of the capital gains tax on stocks they’ll need to pay.
This can be done by subtracting the cost basis (also known as your tax basis) from total proceeds. The cost basis includes the amount paid to buy the stock, commissions or fees paid for buying and selling the shares. From this adjusted amount, the profit is what the investor will pay taxes on; this is called a capital gains tax or it may be thought of as a tax on stock sales.
Capital gains tax
Many investors may see buying and selling stock as an opportunity to incur potential profits and possibly build some wealth. Enduring profits on a stock sale will still require paying taxes, similar to other income-generating activities. Investors will need to remember to pay a tax on stock sales.
Called capital gains, these will set a level for taxes to be paid from selling a stock. When an investor has incurred a capital gains tax on a stock, it will be paid when the stock is sold for more than the initial amount paid. There are both short-term capital gains taxes and long-term capital gains tax. Different factors will define taxes on stock gains and the tax rates will vary.
What is capital gains tax?
A capital gains tax is the tax levied on the profit from selling a stock. When an investor has incurred a capital gains tax on stock sales, it will be paid when the stock is sold for more than the initial amount paid.
How the capital gain is taxed depends on various factors, including an investor’s tax filing status, taxable income, and how long the stock was owned by the investor before selling it. Note the capital gains tax rate isn’t one fixed rate, but its rate is 0%, 15% or 20% on most assets held for longer than a year or based on an investor's income if the asset was held by the investor less than a year.
Short-term capital gains tax
A short-term capital gains tax comes from selling an asset, such as a stock, that has been held for one year or less. The tax rate uses ordinary income taxes rates and it will depend on an investor's taxable income.
For 2023 tax rates (taxes paid in 2024), they will vary from 10% up to 37%. Please be sure to use the correct rates for the tax year as rates may change.
Here's an example. If you bought $5,000 worth of stock in August and then sold it for $6,000 in December during that same year, you’ve incurred a $1,000 short-term capital gain. Now, if you’re in the 22 percent tax bracket, you will owe the IRS $220 from your $1,000 capital gains as an individual filer. After subtracting this, you will then have a $780 net gain.
Long-term capital gains tax
Time is on your side when it comes to a long-term capital gains tax. By holding your asset, such as a stock, for greater than a year, there is the potential to benefit from a lower tax rate on your profits.
For investors who are in the a lower tax bracket, they may not pay anything for their capital gains tax rate. This is because the long-term capital gains rate is derived from an investor's tax bracket; rates for the 2023 tax year are 0%,15% or 20% but may vary slightly annually. Be sure to double-check the rates every tax year.
Here's an example. If you incurred a long-term capital gain for the 2023 tax year and your income as a single filer is $40,000, then you'll pay $0. If your income is $50,000 and you've incurred a $500 capital gain, then you'll pay a 15% rate, then you'll owe $75.
Dividend stocks
Dividend stocks are typically from well-established companies with a history of distributing earnings back to shareholders. Some well-known dividend stock companies that you may know include International Business Machines (IBM), Cisco Systems (CSCO), and Taiwan Semiconductor Manufacturing (TSMC).
Over time, investors may see dividend stock companies increase their dividend payouts throughout the year with an average dividend on some dividend stocks reaching over 10%. Some investors may reinvest their dividend payouts rather than take the income. The timeframe for dividend distribution is typically each quarter, but it varies as some companies may also pay dividends semiannually or yearly.
How are dividends taxed?
Most investors understand receiving dividends is considered income but some don't always remember it's not free money; dividends are taxable income and the taxes on them are due in the same tax year they’re received.
There are two dividend types for tax purposes: qualified and nonqualified (or called "ordinary" because the Internal Revenue Service (IRS) taxes them as ordinary income.). Different factors define these dividend types and investors will pay different tax rates holding them.
For qualified dividends, three tax rates of 0%, 15% or 20% apply based on an investor's taxable income and filing status while nonqualified dividends are taxed as income with tax rates up to 37%. Investors in higher tax brackets will pay a higher dividend tax rate for both dividend types and the IRS form 1099-DIV is sent to individuals to help them correctly report their annual dividend incomes.
Non-qualified (or ordinary) dividends
It's important to define non-qualified dividends. Non-qualified or ordinary dividends can come from different sources including real estate investment trusts (REITS), master limited partnerships (MLPs) and some specific foreign corporations; however, they are not eligible for lower capital gains rates.
Ordinary dividends are taxed at an investor's tax bracket. For example, if they are in a 32% tax bracket, then their ordinary dividends would have that tax rate.
Qualified dividends
If a dividend is to be classified as a qualified dividend, then it needs to meet certain criteria. This includes the following:
A U.S. company or a qualifying foreign company must pay the dividend.
If you owned a stock for more than 60 days in the 121-day period that started 60 days before the ex-dividend date (the day the stock begins trading without the value of its next dividend payment). The stock must meet this time period.
Dividends cannot be either payments from tax-exempt organizations or capital gains distributions.
If a dividend meets qualified dividend defintion, then the investor will pay one of three tax rates: 0%, 15% or 20%, based on their taxable income and filing status. For example, an investor is single and they have an income greater than $41,675, they'll incur a 15% tax rate on the qualified dividends.
When are taxes due on your stock trading?
Many investors ask, "When do you pay taxes on stock sales? The good news is they only pay taxes on stocks once: when they are sold.
Investors may see a stock’s value change in their portfolio—whether it’s a rise or decline—but if they let the stocks remain there, no taxes will be due.
If you have a stock that has increased in value, sitting in your portfolio but you haven’t sold it, this is referred to as an unrealized gain. On the other hand, if you own a stock that has declined in value, and you continue to hold on to it for now, then you’ve incurred an unrealized loss.
Selling stocks at a loss may be advantageous for your tax situation. If you decide to sell the declining stock and it’s sold at a loss, then you won’t incur any taxes. This may be advantageous to your tax strategy and it has a name: tax-loss harvesting.
Keep in mind, if we flip the situation and you decide to sell a stock that has increased in value and it brings a profit, then you’ll need to pay a capital gains tax. And this will be required to do so in the same year that you sold the profitable stock as selling stock taxes are paid annually.
How to identify when your stock profits are subject to taxes
Selling stock can help investors achieve their investing goals and potentially gain some income. Paying taxes is typically part of the process; however, there are some strategies that can help investors minimize their tax liabilities. This can come from different ways.
Investing for the long-term can help investors benefits from long-term capital gains rates. Holding on to investments and not selling them will not incur taxation. Taxes only occur when there are stock sales.
If an asset, such as a stock, is held longer than a year and a capital gain has been occurred, the tax rates on these capital gains can be lower than an investor's ordinary income tax rates. For the 2023 tax year, this is 0%, 15% or 20% based on taxable income and filing status.
Depending on your tax rate, you may want to consider other assets for your portfolio, such as ETFs or municipal bond funds. A municipal bond's interest may be exempt from federal taxes and state and local taxes, depending on your resident state.
Investment accounts are another way. These accounts can help investors not only achieve savings goals, such as a retirement, they can also offer tax advantages.
Whatever tax efficiency strategies you choose, it's important to also speak with a tax professional.
Using a tax-advantaged stock account
A tax-advantaged account is an investment account that offers investors tax benefits when used for a specified savings goal such as retirement. Savings can be made in different accounts such as 401(k), 403(b) or individual retirement accounts (IRA).
Investing in an tax-advantaged investment account can help eliminate capital gains taxes on your portfolio. You can buy and sell stocks, bonds, and other assets without triggering capital gains taxes. Withdrawals from a traditional IRA, 401(k) and similar accounts may lead to using ordinary income taxes. However Roth IRA accounts, another IRA accounts, eliminate taxes on eligible withdrawals if certain conditions are met.
Net investment income tax
As an investor, if you made money from your investments, you may pay a net investment income tax at the annual tax filing time. It is important to determine if you will be hit with this tax to avoid any potential surprises.
There are two factors at play for this potential tax: your net investment income, such as dividends, interest, rental property income, and your modified adjusted grow income (MAGI).
What is net investment income tax (NIIT)? This is the 3.8% surcharge on the lowest number between the NIIT and the amount of an investor’s MAGI that goes past their income threshold.
FAQ About Taxes on Stocks
Do I pay taxes on stocks I don't sell?
No, you don’t pay taxes on unsold stocks or unrealized capital gains. Until stock shares are sold, you will not be taxed—regardless of how long you’ve either held the shares or the amount they’ve increased in value. But do note: when it comes to taxes, most tax payers pay a higher rate on their taxable income vs. long-term capital gains they may have incurred.
What happens if you sell a stock but don't withdraw money?
If the stock was sold in a retirement account, such as an IRA, 401(k) or 403 (b) then taxes won't be owed until the money is withdrawn.
If the stock had been sold in a taxable brokerage account, taxes are owed if the stock had been sold for a profit. This capital gain is reported on an individual's tax return and the amount due depends the length of time the stock was held and annual income. With a stock sale loss in a taxable brokerage account, an investor won't owe any taxes; this may potentially lower a tax bill.
Do I have to pay capital gains tax immediately?
No, you are not required by any rules to pay a capital gains tax at the time you've sold an asset. But if you are in a situation where you may owe $1,000 in taxes or more, you could make these estimated tax payments during the year. If you plan ahead for this tax debt, it could help you avoid interest and penalties.