Tuesday, October 13th, 2015

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Tax Basics for Investors

Nothing is certain but death and …well, you know the rest. It’s hard to imagine a more unpopular topic than taxes, but it’s important that you understand how Uncle Sam always gets his due when it comes to investing. After all, every dollar you pay unnecessarily in taxes is a dollar that won’t be around to grow as part of your long-term plan for financial success.

Fortunately, a little bit of knowledge can go a long way towards minimizing the burden of taxes in your portfolio. Here are a few basic terms and concepts you need to know:

Dividends and Interest

First, dividends and interest (such as from a money market fund or a bank account) are taxable as ordinary income when you file your tax return with the IRS. Reinvested dividends are taxed just as if you received them in cash.

If you still own a stock or index shares and haven’t sold, you won’t have to worry about taxes, even if the shares have increased a lot in value. But anytime you sell a security at a profit, you trigger a capital gain. Conversely, when you sell a stock and lose money, you register a capital loss. Capital gains are taxable when you file your annual return with the IRS on Form 1040 and Schedule D. (Sorry, you can’t file using Form 1040-EZ if you have capital gains in the year.)

Selling Stock

It’s easy to figure the capital gains on any sale of stock, as well as the taxes that you’ll pay the IRS (and possibly your state). First, you’ll need to know the cost basis-how much you spent to buy the shares in the first place (including any fees or commissions). Subtract your cost basis from the amount you received from selling the shares (after any fees or commissions), and you’ll know the amount of capital gains or losses.

It gets a little more complicated if you’ve made more than one purchase of the stock that you’re now selling. Each individual purchase, whether it was 0.564 or 3,500 shares, is considered a single tax lot.

When you sell, if you don’t sell all of the shares you own, you can use what IRS regulations call the "first in, first out" (FIFO) method of figuring your basis. In other words, the first lots of shares that you purchased are the first that you sell, and you must figure your capital gains or losses accordingly.

Cost Basis

Another method that is used is to sell specific lots and use the cost basis of each designated lot. You should consult your tax advisor for more information about this method.

Capital Gains Tax

Not all capital gains (and capital gains taxes) are equal. Capital gains taxes decrease the longer you hold a stock before selling. The federal tax rates for capital gains are pegged to two separate holding periods: Short-Term and Long-Term.

You must pay Short-Term gains on stocks that you owned for less than 12 months. The tax is the same as the rate you pay on your ordinary income. If you’re in the 28% tax bracket, you’ll pay a 28% tax on any reported short-term gains. If you’re in the 39.6% tax bracket, that’s your tax on short-term gains.

However, if you hold a stock for twelve months or longer, the Long-Term capital gains tax rate kicks in. For most taxpayers, that’s just 20%. (See how you could pay lower taxes just by holding on to stocks for a longer period?)

For taxpayers in the 15% tax bracket, there are even lower taxes for both categories of capital gains (15% for Short-Term gains and just 10% for Long-Term gains). Consult your tax advisor for more information.

Finally, what happens to the stock of a bankrupt company when it becomes nearly worthless or is no longer trading? This has been all too common in recent years, but IRS regulations state that you can’t record the capital loss if you’re still holding the worthless shares.

To devoid yourself of nearly worthless stock, you can effect a "penny-proceeds" sale through ShareBuilder; or for non-trading stock, you can relinquish ownership by turning over the stock to ShareBuilder as "worthless". Either action is necessary so that you can officially record the loss on your tax returns.

© 2008 ShareBuilder Corporation. ShareBuilder is offered through ShareBuilder Securities Corporation, and a registered broker-dealer and member NASD/SIPC, and a subsidiary of ShareBuilder Corporation. ShareBuilder is not affiliated with Young Money. Call (800) 215-4679 with questions about ShareBuilder.

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3 Responses to Tax Basics for Investors

  1. Morp says:

    Are capitol gains reported on a 1099 form? If I understand this right, I can buy and hold some etf’s and I won’t have to worry about reporting any capitol gains/losses until I sell my shares. However, I would have to report any dividends earned each year. Is it fairly simple to report dividends, meaning I don’t have to worry about reporting the number of shares purchased and at what price every single year? Thank you!

  2. Ranger Bob says:

    I think there’s a couple mistakes in this article. Feel free to chime in if I’m wrong.

    “First, dividends and interest (such as from a money market fund or a bank account) are taxable as ordinary income…”

    Interest income is ordinary income. However, dividends are usually treated as long term capital gains. Exceptions would include distributions from MLPs and most bond income.

    “However, if you hold a stock for twelve months or longer, the Long-Term capital gains tax rate kicks in. For most taxpayers, that’s just 20%”

    The 10/20 rates were replaced by 5/15 in 2003. This lasts until 2010. After that, it depends on who’s president. There’s a zero rate in 2008 too, for certain incomes conditions. There are also 25 abd 28% conditions, but those are really limited. Overall, most people will be paying 15% on long term capital gains.

    Morp: Yes, you just report the dividend income. You should receive a 1099-DIV. You don’t report share information until you sell.

  3. JOHN R. says:

    do you have to stay out of the stock you sold for 30 days before you can buy back in so as to not loose your long term capatiol gains ?

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