# Five Quick Questions About Stocks and Taxes

The idea of investing in stocks (outside of retirement accounts) can be rather stressful if you’ve never done it.

Just figuring out what to invest in can be really confusing. Am I doing the right thing? Is this worth the risk? When you add taxes to the equation, it can get really, really confusing – and troubling.

Once Sarah and I reached debt freedom, we needed to figure out how to invest our money. We chose to invest at least some of it in stocks. In doing so, we figured out a lot of things about stock investments, but we also learned some things about taxes. Here are the questions that scared us the most in this process, along with simple answers to those questions.

## What are “capital gains”?

A capital gain occurs any time you buy something and it gains value. If you buy something for \$100 and the value goes up to \$200, you have a \$100 capital gain on that item. The item could be anything – a baseball card, a piece of art, or a share of stock.

You “realize” that capital gain when you choose to sell the item. So, if I choose to sell that \$200 item, I’ve “realized” that capital gain. That’s the part that the IRS actually cares about, because that sale is usually an event that creates income for you. You’re going to owe income taxes on that \$100 you gained.

## How are “capital gains” taxed?

Capital gains are split into two groups.

Short term capital gains are those that come from items that you owned for less than a year. These are usually taxed at a higher rate. As of now, short term capital gains are taxed at the same rate as any other income. So, if you buy a baseball card for \$100 and sell it for \$200 less than a year later, you earned \$100 in short term capital gains and, as of 2014, you’re going to have to pay ordinary income tax on that item.

Long term capital gains are gains that came from items that you owned for more than a year. These usually have a lower tax rate than short term capital gains. Right now, the long term capital gains tax rate is 15%, unless you’re in the absolute highest tax bracket, in which case it’s 20%, or you’re in the lowest tax brackets, in which case it’s 0%.

So, let’s say you are in the 25% income tax bracket. You buy a \$100 item and it quickly goes up in value to \$200. If you sell it less than a year after you buy it, you’ll have \$100 in short term capital gains and you’ll have to pay the full income tax rate on that, so you’ll add \$25 to your income tax bill. If you sell it more than a year after you buy it, you’ll have \$100 in long term capital gains and you’ll only have to pay 15% on it, so you’ll add only \$15 to your income tax bill.

Dividends are small payments that companies give out to every shareholder. For example, if a company issues a \$0.10 dividend, that means that the company is paying out ten cents for every share of stock that’s out there. If you hold 10 shares of that stock, you’re going to get a dollar from that dividend payment.

Many stocks pay out dividends every three months. For example, in February, Verizon paid a dividend of \$0.53 per share.

So, let’s say you own 100 shares of Verizon stock. Every three months, Verizon will most likely pay you a dividend for each share (they have a long history of doing so and have no reason to stop). At their most recent rate, \$0.53 per share, that would add up to \$53.

How do taxes work on that? Well, just to make things confusing, there are two different ways that dividends are taxed. If you’ve held the stock for a while (there’s an exact formula for this, but it mostly comes down for having owned the stock for the past several months or longer), the dividend is considered a “qualified dividend” and is treated like a long term capital gain in terms of taxes. All other dividends you earn are “ordinary dividends” and are treated like ordinary income.

In general, if you’re an American and you buy a share of stock in an American company, the first two times it pays you a dividend, it will probably be ordinary income. After that, it should be a “qualified” dividend and you’ll pay a lower income tax rate on it.

This is an example of how tax laws really help the wealthy. If you own a ton of stock and just sit on it and the stock pays dividends, you’re receiving “qualified” dividends and paying a lower income tax rate on them. If all of your income is qualified dividends and you have a bunch of tax deductions, your tax rate is going to be quite low.

This is where things can get really messy, and it’s a good reason why you need to be really careful investing in mutual funds and index funds outside of a retirement account. When such investments are inside a retirement account, none of this directly applies to you.

A mutual fund is made up of a bunch of different investments. Let’s say you own shares in a mutual fund that’s made up of 100 different stocks. That fund is run by someone who is making decisions on behalf of the fund – that person is deciding when to buy stocks, when to sell stocks, and so on.

Whenever the manager of that mutual fund sells a stock and earns a capital gain on that sale, you are going to be paying taxes on your share of that capital gain. You’ll receive a 1099-INT form at the end of the year that outlines exactly how much that capital gain is for you.

The kicker is that, usually, you don’t receive any of that money. It’s simply reinvested in the fund. You just owe taxes on that money.

This can hurt badly if you’re in a fund where the manager trades a lot because it’s a tax bill you have to pay without ever having received any money. You want to avoid this kind of activity if you can.

Another problem is with “qualified” dividends, as mentioned above. When a mutual fund manager buys something new, the dividends that are created by that new investment aren’t considered qualified until they’ve been held for a while. So, you might have owned shares in that mutual fund for a long time, but when the tax bill comes, some of your dividends will be qualified and some might not be.

This is why many companies advertise “tax efficient” mutual funds. These are funds where the people in charge of the fund mostly just buy and hold, only selling if they absolutely have to. These kinds of funds rarely generate these kinds of taxes or ordinary dividends.

If you’re investing with your own money outside of a retirement account, you should either focus entirely on very tax efficient mutual funds or avoid such funds entirely.

What did Trent and Sarah do?

Our stock investments are made up almost entirely of index funds, which are designed to just buy and hold, which means that they have very small capital gains (if any) so there are very few taxes involved. If the fund does have to make a sale (because some investor pulled out), they try very hard to balance the sales so that there are no total capital gains or losses. We mostly own VTSMX, which hasn’t distributed capital gains in a long while, so all we pay taxes on are the dividends. Most of those dividends (almost all) are qualified, so we pay a lower tax rate on them.

If we choose to sell these investments, almost all of the gains will be long term capital gains at this point. So, let’s say we’ve invested \$50,000 over the years and it’s grown to \$80,000. We choose to sell all of it. We would get a check for \$80,000, but we would owe only a 15% tax on the \$30,000 that we gained – \$4,500, in other words.

Overall, the taxes on this investment are pretty simple – we’ve never had a problem or a big unexpected tax bill – and the investment is very efficient. We’re quite happy with it, even though we were worried about tax headaches when we started investing.

##### Trent Hamm
###### Founder of The Simple Dollar

Trent Hamm founded The Simple Dollar in 2006 after developing innovative financial strategies to get out of debt. Since then, he’s written three books (published by Simon & Schuster and Financial Times Press), contributed to Business Insider, US News & World Report, Yahoo Finance, and Lifehacker, and been featured in The New York Times, TIME, Forbes, The Guardian, and elsewhere.