Many 20-somethings I know find filing taxes to be as overwhelming and scary as the prospect of plowing money into the market.
But really, both aspects of money management are easy to tackle once you understand the basics … plus, they actually overlap in one case: capital gains taxes.
See, when you put money into the market, the goal is simple: to end up with more than you started with. If you are successful in that endeavor — say you buy a stock for $50 per share and later sell it for $100 per share — you have made a profit, or a capital gain.
Of course, this is America, so that gain gets taxed.
Here are five scenarios for young investors, and what you need to know about capital gains taxes for each of them:
1. I haven’t bought any stock: Obviously, you don’t owe any capital gains taxes if you aren’t even in the market (although you could still owe capital gains taxes if you invest in real estate or other assets). If this is the case, you should be in the market. Don’t make me say it again.
2. I haven’t sold my stock: I suspect most young investors just getting started — like myself — are in this boat. I bought McDonald’s (NYSE:MCD), for example, a few months back and it has increased in value thus far. But a capital gains tax is a percentage of all realized gains … and a gain is only realized once the asset is sold. Thus, I don’t have to worry about capital gains taxes until I sell my MCD shares.
With that in mind, another important thing to note is that your realized investments are based on the calendar year. If I were to sell McDonald’s right now, I wouldn’t have to file the income from it until I do my 2013 taxes.
3. I sold my stock and lost money: Don’t fret if you finally forayed into the market and lost some money — it happens to everyone. Besides, you can write off that red! If your capital losses exceed your capital gains, you can claim up to $3,000 of that loss. And if your loss is even more than that, you can carry it forward to later years and include it in your calculation for “net long-term capital gains.”
4. I sold my stock and made money: Hooray! You cashed out of the market and actually made money! Now what?
Well, first you have to figure out your capital gain. As InvestorPlace Jeff Reeves recently explained, this is relatively simple: “Figure out the price you sold your stock or mutual fund at (including commissions), subtract “cost basis” on your initial investment and — voila!” (Here’s more reading on calculating your cost basis, including special rules that sometimes apply.)
But there’s a little more fine print. See, there are two types of capital gains — long-term and short-term. If you hold your asset for more than a year, you generally pay lower taxes than if you hold it for less than a year. (To determine how long you’ve held the asset, count from the date after the day you acquired it up to and including the day you disposed of it.)
As a general rule, short-term capital gains tax — applied to all short-term assets — is the same rate as your regular income tax. If you are in the 20% bracket, you pay 20% on your short-term investment gains, if you’re in the 35% bracket, you pay 35%, and so on.
Long-term gains, on the other hand, include all your profit from long-term assets, but back out any long-term capital losses (including any unused losses from previous years). These investments are generally taxed at rates no higher than 15% (unless, starting in 2013, you earn over $400,000 per year … but that’s not going to affect most recent grads).
There’s more, though. Many long-term capital gains may actually be taxed at 0%. This is the case if you fall into the 10% or 15% income brackets — a possibility for many millennials considering the upper limit is $36,250 for singles.
If you only make $32,000 a year, for example, any extra gains up to that threshold (so the next $4,250 in this example) don’t get taxed. Only the gains remaining once you hit $36,250 will face the 15% rate.
5. I was paid a dividend: If you bought a stock that has pays out a dividend — a cash payment to shareholders — then any payouts during the tax year must also be reported, regardless of whether you are still holding the stock, sold it or reinvested your dividends.
For example, McDonald’s theoretically will pay me 77 cents per share every quarter. Once those payouts add up to at least $10 in total, I will have to file a 1099-DIV form reporting that income. Ordinary dividends — which, as the IRS explains, you can assume you are receiving on any common or preferred stock unless the paying corporation or mutual fund tells you otherwise — are simply taxed as regular income.
Of course, there are also “qualified” dividends, which have slightly different requirements and rules. You can read more about them here. But the most important thing is to be aware that dividends require a separate form and separate taxes than capital gains.
The Bottom Line
With these nuances in mind, investors sometimes are better off making slight maneuvers, such as holding their investments for at least a year to get a lower tax rate, or “harvesting” losses just before the end of the year.
But those kinds of tax strategies are for another day. For now, just remember that when you do make some money in the market, the tax man is going to come a-knockin’, so make sure you’re prepared.
For your reference, also check out the IRS webpage on capital gains and losses and the 1040 form you will have to fill out.
As of this writing, Alyssa Oursler was long MCD and craving a McGriddle.
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