How to Pay Taxes on Stock

Who doesn’t love passive income? In fact, people nowadays are way more interested in earning passive income more than ever. The fact that you can earn a handsome amount of money without toiling that hard is very enticing. Talking about passive income, the first option that should pop up in our mind is investing in stocks, right?

Well, it is not a herculean task to understand that stock investment is one of the greatest sources of earning passive income not only in the United States but all over the world. People have literally built empires by investing in stocks as profit margins can be really high. You may not believe it, but you can actually earn a lot even with a minor investment.

All of this sounds very exciting, but good things are mostly accompanied by “unwanted” ones. With that being said, it is important to note that any profits (capital gains) earned from stocks are also taxed, just like gains on any other asset. Selection of the right stock for investment purposes is never easy because there are many factors to consider, and taxation of the stocks stands in the top ranks.

Of course, you must know when to buy and when to sell your stocks, but you must add taxes to your overall strategy unless you are happy to pay “unnecessary” taxes. This article will explain everything you need to know about capital gains tax and different ways to minimize it. Let’s start with the basics first.

What are Capital Gains?

Simply put, capital gain occurs when we sell a capital asset with a profit. i.e., when the selling price of that capital exceeds the purchasing price. Here is the equation for this concept:

Capital gain= Sale price- purchase price

Now, the government not only takes its cut/share from your income, but it also wants its share on any profits/gains realized from any capital investment, and this is commonly known as capital gains tax. Now, the word “realized” is very crucial for taxation purposes, and understanding the difference between unrealized and realized gains is mandatory.

A gain will be considered as unrealized as long as the asset is not sold at an appreciated price. For example, you have bought the stock of a specific company for $10 per stock, and two years later, its value reached $18 per stock. Now, there is an increase in the value of the stock, but the government cannot tax you unless you sell that stock and realize the profit. Apart from that, taxation is different for long and short-term capital gains.

Short Term Capital Gains Tax:

It is the gain/profit realized when an individual sells capital assets after holding them for 12 months or lesser. As far as these capital gains are concerned, the tax rates for them are almost the same as the usual tax bracket.

Long Term Capital Gains Tax:

It is the profit/gain realized when an individual sells capital assets after holding them for more than 12 months. Tax rates for these gains are discussed in the latter part of this article.

In the United States, under normal circumstances, long term capital gains are more favorable in terms of taxation as tax rates are pretty lower as compared to short term capital gains. Let’s take an example of how capital gains are taxed.

Taxation on Capital Gains Explained With an Example

Let’s say you have bought stock (100 shares) of a company named ABC where the price per share is $20. Now, assume that you sold those shares for $50 each after holding them for more than a year. Suppose, based on your income category, the tax rates for your long term capital gains is 15 percent. Your gains and taxes are calculated as follow:

Purchasing price of 100 shares ($20/share) $2,000
The selling price of 100 shares ($50/share) $5,000
Capital gain $3,000
Capital gain (tax rate is15%) $450
Profit after tax (PAT) $2,550

These 450 USD will go to the government treasury, but this rate could have gone really high if you had sold your shares within 12 months of the purchase. As a matter of fact, this rate could have gone up to 37 percent in case you had not held them for more than a year, and you might have been facing state taxes as well.

Capital Gains (Long Term) Tax Rates in 2020

Single filers

Tax Rates Income Range
0 percent 0 - 40,000 USD
15 percent 40,001 - 441,450 USD
20 percent 441,451 USD or more

Married, filing jointly

Tax Rates Income Range
0 percent 0 - 80,000 USD
15 percent 80,001 - 496,600 USD
20 percent 496,601 USD or more

Head of the household

Tax Rates Income Range
0 percent 0 – 53,600 USD
15 percent 53,601 – 469,050 USD
20 percent 469,051 USD or more

Married, filing separately

Tax Rates Income Range
0 percent 0 – 40,000 USD
15 percent 40,001 – 248,300 USD
20 percent 248,301 USD or more

How Can You Figure Your Capital Gains Tax

A lot of individuals mostly calculate their taxes with the help of software, which makes all the computations automatically. Moreover, you can get a rough idea by using a capital gain calculator. You can use free online tax calculators.

Methods to Avoid or Minimize Tax on Capital Gains

Different ways can be used to reduce the tax on capital gains, and here are a few of them:

Long Term Investment

One of the best ways to minimize the capital gains tax is to invest in stocks for longer periods. Yes, it sounds easier on paper, but it can be less pragmatic. However, if you invest in consistent and successful companies and hold it longer, you will get greater profits and lesser tax.

Set-off Your Capital Losses with Your Capital Gains

Another option you can use to minimize capital gains tax is the setting of your capital losses with capital gains. Suppose you owned stocks in two different companies and you sold them in the same tax year. Now, if you suffered losses on the sale of one stock and earned a profit on another stock, you can set off the losses with profit from another stock.

However, if the capital losses exceed that year’s capital gains, you can set off your losses with your ordinary income, but the maximum limit is $3000. You can settle the remaining losses in tax years to follow.

Monitor Your Holding Period

Keeping an eye on the purchase’s trade date is very important if you are going to sell your shares, which you purchased about a year ago. If the stock prices are relatively consistent and waiting for a few days or even weeks can put you in the long term capital gains category, then waiting a little longer will be fruitful.