How to Pay Taxes on Stocks

Through stock market investments, it is possible to establish independent wealth over the long-term. As part of the wealth creation process, you must learn to trade stocks in a tax efficient manner. To do so, you will study basic tax law as it relates to capital gains and dividends. From there, you are better able to put together a portfolio that matches your financial objectives. Be advised that the U.S. tax code is more so favorable for long-term investors.

Stock Market Returns

Stock market returns are a function of both capital gains and dividend payments. Capital gains relate to share price appreciation that occurs after buying into a stock. While holding stock, you may also collect dividend payments out of the profits of the underlying business.

You will generally owe taxes on realized capital gains and dividend income--for the tax year in which they occur. You realize capital gains when you sell shares of stock at a profit. At tax season, your brokerage will prepare 1099 forms that document your trading activity. With this information, you will complete Schedule D alongside Form 1040 to report stock market returns to the IRS.

Capital Gains Taxes

When calculating capital gains taxes, you must first become familiar with the concept of cost basis. Cost basis includes brokerage commissions within your acquisition costs for buying stock. For example, you may transact stock market business through an online broker at $10 per trade. If you buy 20 shares of Stock X for $50 per share, your cost basis would be $1,010 ($50 x 20 = $1,000 + $10 = $1,010). Three years into the future, you may sell Stock X for $95. Total proceeds on the sale would then be $1,890 ($95 x 20 = $1,900 - $10 = $1,890). You would then be responsible for paying taxes on $880 in capital gains ($1,890 - $1,010 = $880).

For tax purposes, capital gains are categorized as either short-term or long-term capital gains. As of 2010, short-term capital gains are taxed at ordinary income rates of 10, 15, 25, 28, 33, and 35 percent. Long-term capital gains are either tax-free or taxed at 15 percent rates. For long-term capital gains, you must own a stock for more than one year.

If your stocks fail to perform, you can deduct up to $3,000 in realized capital losses from your taxable income. Losses that exceed the $3,000 limit can be carried forward as deductible items in future years. The IRS does prohibit capital loss deductions on wash sales, where you sell a stock at a loss and immediately buy it back within 30 days.

Taxes on Dividends

In a similar format to capital gains, cash dividends on stocks are classified as ordinary and qualified dividends. Ordinary dividends are taxed at ordinary income rates of 10, 15, 25, 28, 33, and 35 percent. Qualified dividends, however, are either tax-free or taxed at maximum 15 percent rates.

For qualified dividends, you must own shares of stock for at least 61 out of the 120 days surrounding its ex-dividend date. You will buy and hold shares before and through the ex-dividend date to receive dividends on the next payable date.

Retirement Accounts

401(k), Traditional IRA, and Roth IRA plans allow for tax-deferral. Tax-deferral means that you are not responsible for paying taxes on capital gains and dividends as they occur within your retirement account. You fund 401(k) and Traditional IRA plans with tax-deductible contributions. Upon withdrawal, these retirement account balances are generally taxed as ordinary income. A Roth IRA is the mirror image of the 401(k) and Traditional IRA. Roth IRA contributions are made with after-tax money, which allows for tax-free withdrawals at retirement. Be advised that retirement account withdrawals made before age 59 ½ may be subject to a 10 percent additional tax penalty.

Investment Strategy

Your ultimate goal when trading stocks is to generate the highest returns for the least amount of risk. Making money on stocks does not always translate into a minimal tax bill. For example, you should not hold onto a bad investment for the sole purpose of writing off stock market losses.

How to Pay Taxes on Stocks, Sources:

IRS: Capital Gains and Losses

IRS: Dividends

IRS: Investment Income and Expenses