What if your capital gains are negative?
Sometimes, you may not have any gains when you sell investments. In some cases, you may even find yourself with capital losses.
Here’s how this works for the purposes of investing and taxes: You can use capital losses to reduce your capital gains. In other words, if you sell a stock at a $5,000 profit but sell another stock at a $1,000 loss, your taxable capital gain for the year is $4,000.
You must use long-term capital losses to offset long-term gains before applying them toward short-term capital gains. Conversely, you have to use short-term losses to reduce short-term gains before using them to reduce any long-term gains.
In the event that your capital losses are greater than your capital gains in a given year, you can use them to offset your other taxable income. This deduction is capped at $3,000 per tax year (or $1,500 if married and filing separately). However, if your net capital losses exceed the capped amount, you can carry them over to subsequent years.
Dividend taxes: When you receive shareholder profits
Capital gains and losses aren’t the only important part of investing and taxes. Dividends (earnings distributed by companies to shareholders) are also taxed, at a rate depending on the classification.
Just like with capital gains taxes, dividends have two basic classifications for tax purposes: qualified dividends and ordinary dividends. Qualified dividends are taxed at the long-term capital gains rates. Ordinary dividends, on the other hand, are taxed as, well, ordinary income.
To be considered a qualified dividend, two basic requirements must be met:
- The company that paid the dividend must be a U.S. corporation or a qualified foreign corporation, which generally means the stock is traded on U.S. exchanges.
- You must have owned the stock for 60 days during the 121-day period starting 60 days before the stock’s ex-dividend date and ending 60 days afterward. (Preferred stock has a stricter ownership requirement of 90 days out of the 181-day window beginning 90 days before the ex-dividend date.)
Some dividends are never considered “qualified.” These include dividends from tax-exempt organizations, capital gains distributions, dividends paid on bank deposits (for example, credit unions often pay dividends on deposit accounts), and dividends paid by a company on stock held in an employee stock ownership plan (ESOP).
In addition, dividends paid by pass-through entities, such as real estate investment trusts, or REITs, are typically considered ordinary dividends, although there are exceptions.
Interest income: When you earn interest on cash or bonds
The final type of income to note for investing and taxes is interest income, which is typically taxed as ordinary income. This includes interest payments you receive on fixed-income investments (bonds) you own, as well as any interest your brokerage pays on cash balances in your account.
One big exception is municipal bonds. Generally speaking, the interest paid by municipal bonds is exempt from taxation.
IRAs are exempt from most investment taxes
An important distinction to make regarding investing and taxes is the difference between a standard (taxable) brokerage account and an individual retirement account, or IRA.
The rules for investing and taxes we’ve laid out here only apply to investments held in a taxable brokerage account. IRAs allow you to invest on a tax-deferred basis.
In other words, an IRA account is not subject to capital gains taxes on the sale of profitable investments or taxes on dividends received. Additionally, you don’t need to report interest income you receive in your IRA.
With a traditional IRA, your contributions to the account may be tax-deductible. Plus, you only pay tax when you withdraw money from the account — in which case your withdrawals are considered taxable income. Roth IRA contributions are never tax-deductible, but qualifying withdrawals are 100% tax-free.
In short, IRAs have some excellent tax advantages over standard brokerage accounts. The trade-off is that you usually leave your money in an IRA until you’re at least 59 ½ years old (with a few exceptions).
While the IRA versus taxable brokerage account decision is a bit more complex than this overview allows, the tax differences — and withdrawal flexibility — are often key deciding factors when choosing which type of brokerage account to open. This is just one of the ways in which learning about investing and taxes is part of a successful investment strategy.
View more information: https://www.fool.com/the-ascent/buying-stocks/investing-and-taxes/