Capital gains tax and Dividend income tax
When you trade stocks held in taxable accounts taxes can have a large impact on your overall return on investment. Investors need to understand how taxes work in order to make the best trading decisions. The profit you earn from a stock can be taxed in two ways:
- Capital gains tax
- Dividend income tax
Capital gains tax
When you realize a profit selling a stock that is held in a taxable account you pay a capital gains tax. If you sell a stock at a loss it can be used to offset gains from other stock sales. The amount you will have to pay on the profit depends on how long you held the stock and what your marginal income tax bracket is.
If you hold a stock for more than one year before you sell it you will pay tax at the long term capital gains rate. In 2013 the long term capital gains rate was 15% if you were in the 25% to 35% marginal income tax brackets, 20% if you were in the 39.6% top marginal tax bracket and 0% if you were in the 1015% marginal tax brackets. Since the tax laws can and do change over time you will want to consult the IRS website for the current tax rates.
If you held your stock for one year or less then it is considered a short term gain and is taxed at your ordinary marginal income tax rate. If you are an active trader, short term gain taxes can have a very large impact on your overall return on investment. Consequently you should try to limit the amount of your short term gains as much as possible (hold on to your stock for at least one year and one day so you can qualify for the long-term capital gain rate).
Dividend income tax
If you receive dividends from stocks held in a taxable account you will have to pay the dividend income tax. There are two types of dividends, ordinary and qualified. Ordinary dividends are taxed at your ordinary marginal income tax rate. Qualified dividends, which are ordinary dividends meeting certain requirements, are tax-free if you fall within the 10-15% marginal income tax brackets, taxed at 15% if you fall within the 25-35% income tax brackets, and taxed at 20% if you are in the top income tax bracket (39.5%).
For more detailed information on special situations such as wash sales and exceptions please refer to the IRS Publication 550 and/or ask assistance from a tax consultant.