The Internal Revenue Service collects taxes on money you make from stocks. However, that money might be considered either capital gains or income. The category the money falls into determines when you have to pay taxes on stocks and how much of a tax bite the IRS takes. Your timing when you sell shares also affects taxes due.
Capital Gains Tax
There are no taxes when you buy a stock or while you own the shares. You owe capital gains tax when you sell the stock and only if you make a profit. For tax purposes, the money you invest is called your cost basis and is subtracted from the proceeds of the stock sale to figure your capital gain. You must report capital gains from a stock sale using IRS Schedule D when you file your tax return for the calendar year in which you sold the shares. For example, if you sell shares on December 31, 2013, report the gain on your 2013 return. If you wait a day or two, you would not have to pay capital gains taxes on a sale until you file your taxes for 2014.
Long-Term and Short-Term Gains
A capital gain is either short-term or long-term. Short-term gains occur when you own stock for 1 year or less and are taxed as ordinary income like your salary. A capital gain is long-term if you hold the shares for over a year. Long-term gains are taxed at a maximum capital gains tax rate of 15 percent as of 2013. If you take a loss, meaning your cost basis is greater than the proceeds for the stock sale, you can use it as a tax deduction to offset gains from other investments.
When corporations pay dividends on stock, they are distributing part of the firm’s profits to stockholders. Dividends are not capital gains. Under IRS rules, dividends are taxed as ordinary income. Income tax must be paid on dividends for the year in which they are paid. This includes dividends that are reinvested to buy more stock in the company. As far as the IRS is concerned, reinvested dividends are paid out as cash and thus are taxable income, regardless of the fact that you chose to use the money to buy additional shares.
Sometimes a company issues additional shares of stock instead of paying a cash dividend. Stock dividends of this sort are not considered income because the extra shares do not change the equity value of your investment. Instead, your investment is divided among a greater number of shares. The IRS does require that stock dividends be reported, but they are not taxable income.
Gifts and Inherited Stock
You may receive a gift or inheritance of stock. Stocks you acquire in either case are not taxable when you get them. You will owe taxes on any profits in excess of your cost basis when you sell the shares. For inherited shares, your cost basis is the value of the shares on the date of death of the original owner. The portion that is taxable when the shares are sold is equal to the gain, if any, which occurred after the date of death. Capital gains on inherited shares are always long-term, regardless of how long you own the shares. If you receive stock as a gift, the original owner’s cost basis becomes your cost basis if you sell the shares for more than the original owner paid. If you sell the shares at a loss, the cost basis you use is the original owner’s cost basis or the value of the shares on the day you received them, whichever is less. The capital gain may be either long-term or short-term, depending on how long you own the shares.