If you’re a newbie investor, one of the things that you’re surely wondering (especially during tax season) is whether or not you still have to pay taxes on stocks that you decided not to sell.
So do you or do you not have to pay taxes? Let’s find out.
As a rule of thumb, you are taxed on anything from which you have generated any type of returns as considered official by the government, be it from your day job or your investments.
When it comes to stocks that you don’t sell, the answer lies in “dividends”, which is the profit distributed by a corporation to its shareholders. You’re only required to pay taxes if you have earned dividends. Otherwise, you don’t have to.
The reason for this is that if you didn’t earn dividends from the stocks you own (and didn’t sell), then there isn’t any taxable event that occurred. You can’t be taxed if you didn’t gain anything from them, plain and simple.
A capital gain, as defined by the Oxford dictionary, is “a profit from the sale of property or an investment”. In simpler terms, it occurs when you have sold an asset or security for more than its original value when you acquired it.
It’s worth noting that capital gains apply to any type of asset considered valuable, like investments, a house, a car, and the like. This means that if you bought a yacht for $100,000, for example, you can expect its value to possibly increase over time, and more so if you’ve made any pricey customizations on it.
If you sell it later on for $250,000, then that extra $150K you just made is essentially what your capital gain is.
There are two classifications of capital gains, and those are short-term (for assets/securities held for 1 year or less), and long-term (more than a year). It’s important to know the difference because they are taxed differently.
The U.S. tax system benefits long-term investors, and the longer you hold on to your assets and securities, the more favorable the tax rates are.
Short-term capital gains, on the other hand, are subject to your regular, ordinary income tax rate, which can be much higher.
To put it into better perspective, long-term capital gains tax rates can only go up to 20%, depending on your taxable income. These tax rates in particular are 0% (you read that right), 15%, and 20%.
For short-term capital gains which, as already mentioned, are taxed at your regular rate, it can go up to 37%, based on the seven marginal tax brackets of 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
If you want to avoid the possibility of paying more in taxes, then you might want to consider becoming a long-term investor.
Another helpful thing to understand is the difference between realized and unrealized capital gains.
An unrealized gain is also known as a “paper gain” because it only exists as a potential (or the paper), as in the potential increase of the profits that you own but have yet to sell.
An example is when you buy a stock from a certain company and see a 20% increase in its value a year later. Because you decided not to sell, then your gains only exist as a potential or an idea, hence it’s unrealized.
The gains don’t really belong to you yet because you still own the stock.
Of course, the opposite of that is a realized capital gain, wherein you sold the stock for more than its basis and thus became richer for it. The gains now belong to you and are now realized.
As discussed above, you only have to pay taxes on stocks either when you’ve sold and profited from their sale, or when you’ve decided not to sell but earned dividends.
Again, anything that generated income for you is deemed taxable, and thus must be reported in your tax return.
The good thing about it is that you don’t have to figure everything out on your own, as your broker will automatically provide you with a 1099-B. This form has a detailed list of every single profit you’ve made from your investments and you can go right ahead and copy whatever’s in it into your tax return.
Since we’re on the topic of paying taxes on stocks, any dividends you earn are considered taxable.
Take this example for instance:
Kayla bought $15,000 worth of XYZ789 stock in March 2021. She bought 30 shares worth $500 each and received a $10 dividend for each of those stocks. This means that she now has an extra $300 from those dividends.
Throughout 2021, XYZ789 saw tremendous growth and its price per share increased to $800 by March 1st of 2022 – this also increased Kayla’s market value in XYZ789 from $15,000 to $24,000.
So Kayla now has a total of $300 in dividends plus an additional $9000 in unrealized capital gains.
If Kayla decides to sell all her stocks, she will be taxed on both the $300 dividend and the $9,000 realized capital gain. If she decides to keep them, she will still be taxed on the $300 dividend.
Why? Because unlike the $9,000 that she didn’t actually earn by deciding not to sell her stocks, the $300 is the income that she made from the dividends.
However, if XYZ789 doesn’t distribute dividends and she didn’t sell her stocks, then there are no taxes for her to pay because no taxable event has occurred.