Do You Pay Taxes on Stocks? Key Details You Should Know

This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment advisor before making investment decisions.

Investing in the stock market can be a way to make your money work for you. Even if you only have a small amount to invest, stocks that increase in value over time can help you build and maintain wealth.

Of course, one thing to be aware of when investing in stocks is how they will affect your income tax. Do you pay taxes on stocks? The answer is complicated because stocks are handled differently than ordinary income. Here’s what you should know about how investing in the stock market may affect your tax bill.

Do you have to pay taxes on stocks?

Taxpayers who are new to the stock market might naturally assume that their tax liability would be based on how much the value of their investments went up or down over the course of the year.

However, the IRS doesn’t tax you based on the value of the investment — unless your stock pays dividends (more on that in a bit). For most stocks, you are only taxed on your capital gains or losses based on when you sell your shares.

Until you sell your stocks, their value is considered “unrealized.” The gain or loss is only theoretical until you actually sell it because stocks can go up or down in value quite quickly. Since the money isn’t in your bank account, it doesn’t count as income on your tax return until you sell your shares.

What you should know about capital gains rates

When you choose to sell your stocks, you will pay taxes on the profit you’ve made. This is called the capital gains tax.

When you decide to sell may influence your ordinary income tax rate, which should guide your investment strategy. For example, short-term capital gains from tax investments could change which income tax bracket you fall under.

Short-term capital gains

If you sell a stock after holding it for less than a year, it will be taxed as a short-term capital gain. Federal short-term capital gains tax rates are the same as ordinary income tax rates. The total taxes that earners must pay on these capital gains depends on their income threshold, with tax rates ranging from 10% to 37% (as of 2022). Tax filers would add their earnings from short-term capital gains to the rest of their income for the year to determine their tax bracket.

Long-term capital gains

If you hold a stock for more than a year before selling it, it will be taxed as a long-term capital gain. Federal long-term capital gains tax rates for stocks are often lower than ordinary income tax rates, with rates of 0%, 15% or 20% based on your tax bracket. However, there are proposals to increase long-term capital gains rates for people who earn $1 million or more.

Taxes on dividends

Some stock accounts pay dividends to their shareholders based on the company’s earnings during the year. Qualified dividends are usually distributed when a company records strong profits. The company that pays out the dividends should also provide a tax form (Form 1099-DIV) that you would submit when you file taxes. Like short-term gains, dividends are considered part of your income for the year and will be used to determine your adjusted gross income and tax bracket.

State taxes

State tax treatment for capital gains varies by state. The majority of states tax capital gains at the same rate as regular income. However, Arizona, Arkansas, Hawaii, Montana, New Mexico, North Dakota, South Carolina, Vermont and Wisconsin have a lower tax rate for capital gains. Some states don’t have capital gains tax at all because they don’t have a state income tax. Consult with a local certified public accountant to confirm regulations for your state, or tax filing software to help with these calculations.

Common practices for keeping taxes down

Understanding the tax implications of when you choose to sell can go a long way in helping to reduce your tax burden. As noted earlier, holding your stocks for over a year rather than buying and selling quickly can lower tax liability. However, this is far from the only option to keep taxes down.

Don’t ignore capital losses

While selling stocks at a profit can increase your total income, some people may sell some of their stock holdings at a loss. This could be because a stock has lost value and you don’t want to lose even more of that investment. You are only taxed on the net gains from your realized stock gains or losses. You can deduct up to $3,000 in capital losses in a single year. If you had extra losses, these can carry over to future tax years.

For example, if you had gains of $5,000 but also losses of $1,000 from stocks you sold this year, you would be taxed as if you had total gains of $4,000. Reporting realized losses can help to lower your tax bill. 

Capital losses can also offset your ordinary income. For example, if you had realized losses of $2,000 in the stock market last year and had no gains, reporting the loss would subtract that amount from your income when determining your tax liability. If you earned $40,000, the reported loss would cause you to be taxed as if you only earned $38,000.

Make stock investments in retirement accounts

Investing in stocks through a retirement plan is popular because it has the potential to deliver a stronger return on investment than a traditional savings account. Retirement accounts can also help reduce your tax liability in comparison to standard stock investments.

For example, stocks and dividends kept in a traditional IRA are tax-deferred, meaning you won’t pay taxes on them until you withdraw money from the IRA account. However, when you invest post-tax income in a Roth IRA, you will be able to withdraw your gains tax-free in the future. 

Making stock investments through a brokerage firm that manages these retirement accounts may help you save for the future while also lowering your tax burden either today or in the future. Keep in mind, however, that withdrawing money from these accounts early will likely result in a financial penalty. IRAs are also subject to yearly contribution limits, so you may not be able to invest as much as you want.

Remember, realized stock investments can affect your tax bill 

So, do you pay taxes on stocks? It ultimately comes down to your investing habits and whether you made a profit by selling stocks during the tax year. If you have concerns about how selling stocks could affect your total taxable income, it may be best to meet with a tax advisor who can offer additional insights into your specific federal income tax requirements.

Investing in the stock market can have a direct impact on your tax bill when you “realize” — or sell — your shares. However, by investing through retirement accounts and claiming losses, you may be able to lower your taxes owed or defer them.

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