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.
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. Similarly, you must use short-term losses to reduce short-term before long-term gains.
If 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 as 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 are taxed like 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 bonds, ETFs, mutual funds, checking and savings accounts, and certificates of deposit (CDs). If your brokerage pays you interest on cash balances, this, too, is taxed as ordinary income.
One big exception is municipal bonds, which are bonds issued by states, cities, and localities. Generally speaking, municipal bond interest is not taxed by the federal government.
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, you don't pay capital gains taxes on the sale of profitable investments or on dividends received through an IRA. Additionally, you don't need to report interest income you receive in your IRA.
There are two kinds of individual retirement accounts: traditional and Roth.
- Traditional IRA: Pay taxes when you withdraw money from the account.
- Roth IRA: Pay taxes when you contribute money to the account.
When choosing between the two, consider tax advantages and withdrawal flexibility. That'll help you decide which account may save you more money over the long run.
All 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 59½ years old (with a few exceptions).
