Are you looking for a way to potentially grow your money outside of your retirement funds but without the consequences of having to pay a huge tax bill at the end of the year?
If so, then investing in stocks might be your answer. This is because stocks can produce what is known as capital gains and dividends. And fortunately, those earnings are subject to lower tax rates than what you’re paying on your employment income.
In this post, we’ll get to know what capital gains and dividends are and how they can help you to lower your taxes.
How Are Capital Gains and Dividends Taxed?
When you get a paycheck from your employer, those earnings are what’s called ordinary income. Ordinary income is taxed according to the U.S. marginal tax system made up of seven brackets as your earnings progressively increase:
10%, 12%, 22%, 24%, 32%, 35%, 37%
When you’ve got what’s called “long-term capital gains” and “qualified dividends”, they are subject to a different, more favorable tax bracket system than ordinary income.
For tax year 2021, here are the brackets and rates for single and married separate filers:
- 0% = $0 to $40,400
- 15% = $40,401 to $445,850
- 20% = $444,851 or more
Here are the brackets for married joint filers:
- 0% = $0 to $80,800
- 15% = $80,801 to $501,600
- 20% = $501,601 or more
To put this in perspective, someone with a salary of $500,000 would pay a top ordinary income tax rate of 35% while another person earning $500,000 from capital gains alone would pay a top tax rate of just 15%.
Notice the words “long-term” and “qualified”. If your capital gains are “short-term” or your dividends are considered “non-qualified”, then they are simply treated like ordinary income and subject to standard tax rates.
What’s the Difference Between Short-Term vs Long-Term Capital Gains?
Capital gains are the earnings you make when your stocks increase in value and are sold for more than what you originally paid.
For example, when you buy a share of stock for $10 and sell it later for $15, you make a capital gain of $5. You don’t pay any taxes on the original $10 because that was purchased at the time with after-tax dollars. Since that $5 capital gain is basically new income, it’s subject to be taxed.
The IRS puts capital gains into two categories:
- Short-term capital gains: Stocks that you held for one year or less.
- Long-term capital gains: Stocks that you held for more than one year.
The major difference between the two is that long-term capital gains receive preferential tax treatment over short-term capital gains.
Let’s say you sell $10,000 worth of stocks to use as a down payment for a vehicle.
If you sell those stocks 365 days after you first purchased them, then they would be considered short-term capital gains and be subject to the higher, ordinary income taxes.
However, if you wait just one more day, then you would have technically held those assets for more than one year. That means they would now be considered long-term capital gains and qualify for the lower tax rates.
What’s the Difference Between Qualified and Non-Qualified Dividends?
Sometimes when companies earn profits, they decide to share a small percentage of those earnings with the shareholders. These payments are called dividends, and they are usually paid out once every quarter.
When the company decides to pass on these profits to you, it creates a taxable event because they’re paying you an income. Hence, just like when you make capital gains, you have to claim the value of the dividends you receive each year on your tax return.
The IRS groups dividends into one of two categories: qualified and non-qualified. For dividends to be qualified and receive preferential tax treatment, they need to be:
- From a U.S. company or a qualifying foreign company
- Not listed with the IRS as those that do not qualify
- You have to have owned the stock for a certain holding period – more than 60 days during the 121-day period that starts 60 days before the ex-dividend date.
Most common U.S. dividend stocks easily meet these requirements. So as long as you hold on to them for approximately 12 months (which you’d probably do anyway to receive the long-term capital gains tax rate), then they should qualify for the lower tax bracket. However, if they don’t, then they will be taxed just like ordinary income.
Creating Tax-Free Income
Using capital gains and dividends to pay lower taxes is a strategy that’s been used by the wealthy for generations. A high-income family earning $1 million from their jobs could pay a top tax rate of 37% while a similar household earning that same income from their securities could pay a much lower top tax rate of just 20%.
Even for modest, middle-class families, this can be a beneficial way to lower your tax bill for the year. For example, if a couple requiring $80,000 per year to cover their living expenses receives it all from long-term capital gains and qualified dividends, then they’d effectively have a zero-tax bill. This is because:
- They could claim a standard deduction of $24,800
- The remaining $55,200 would put them into the 0% tax bracket for long-term capital gains and qualified dividends
Remember to Be Mindful of Your Tolerance for Risk
It’s easy to talk about the potential money you might earn if your stocks go up in value or if you receive dividend payments. However, please keep in mind that any time you invest in stocks, there will always be a risk that your investments could lose value, sometimes for years at a time.
The good news is that long-term historical market trends do suggest that investors with more than 15 years will generally see a positive annual average return (such as 4.24% to 18.93% for the S&P 500). Therefore, it’s important that you’re conscious of these risks and don’t invest too aggressively, especially if you’re not comfortable with the potential for loss.
Whether you’re actively investing in stocks, or you have a variety of retirement funds, the best way to keep up on their performance is to collect their information and condense it into one place. This can be easily done with the help of an app like Buxfer.
Buxfer will automatically log in to your investment and retirement accounts, import the results, and then display everything in one convenient dashboard. This will make it easy for you to see your total gains or losses for any time period as well as gain more insights about your invests such as your total asset allocation.
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