Tax implications

Investors have two main ways to earn a return on stock:

• Dividends
• Capital gains

Stock taxation focuses on these two sources of return. You’ll want to understand how each is taxed and what the Internal Revenue Service (IRS) may require you to report and pay.

Dividends

A cash dividend is income received from common or preferred stock. Investors can also receive dividends from funds (e.g., mutual funds) that pass through income earned by the fund’s portfolio.

Dividends are generally taxed at lower rates than many other types of income. The key distinction is whether the dividend is qualified or non-qualified.

Qualified dividends:

• Taxable at 15% for most investors

• Taxable at 20% for investors at the highest income tax brackets

Non-qualified dividends:

• Taxable up to 37% (based on income tax bracket)

Dividends are qualified when the issuer meets certain requirements and the investor holds the shares for a required holding period (you don’t need the specific rules here). Most dividends investors receive are qualified.

Qualified dividends are taxed at 15% for most people, while investors in the two highest income tax brackets pay 20%. Your reported income affects your marginal tax bracket (covered below): as income increases, the tax bracket generally increases. Only a small portion of taxpayers fall into the highest brackets.

A common example of non-qualified dividends is income from real estate investment trusts (REITs) (covered later). Because this income can be taxed at higher ordinary income rates, REITs often need to offer higher returns to attract investors. Non-qualified dividends are taxable up to 37%, depending on the investor’s tax bracket.

Corporate investors can receive additional tax benefits compared with individual investors. Under the corporate dividend exclusion rule, corporations can exclude (and therefore avoid paying taxes on) a portion of dividends they receive:

Corporations can avoid paying taxes on:

• 50% of dividends if owning less than 20% of the issuer’s common stock
• 65% of dividends if owning 20% or more of the issuer’s common stock

Corporations often maintain brokerage accounts to invest excess cash, which can result in owning shares of other companies. For example, assume General Electric (GE) owns a small portion of Coca-Cola (KO) stock. If Coca-Cola pays GE a $100,000 dividend, GE will only pay taxes on $50,000. If GE owned 20% or more of Coca-Cola, it would only pay taxes on $35,000 of the $100,000 dividend payment (a 65% exclusion).

Dividends are reported annually on tax form 1099-DIV. Brokerage firms send this form to customers and to the IRS. The form shows the amount of dividends received and whether they were qualified or non-qualified.

Timing matters: for a dividend to appear on a given year’s 1099-DIV, it must be paid in that year. If a dividend was declared in 2022 but paid in 2023, it’s reported on the 2023 1099-DIV.

Capital gains & losses

A capital gain occurs when an investor sells a security for more than its original cost. The phrase “buy low, sell high” refers to earning capital gains. If a security is sold for less than its cost, the result is a capital loss.

A gain or loss is realized when the position is closed (long securities are sold, or short securities are bought back). To determine the gain or loss, investors compare cost basis to sales proceeds.

• Cost basis is the total amount paid to buy the security, including any commission.
• Sales proceeds is the total amount received when selling the security, minus any commission.

In other words, cost basis is what you paid in, and sales proceeds is what you took out. Here’s an example:

An investor purchases shares of ABC stock at $50 while paying a $2 per share commission. Several months later, the stock is sold for $70 while paying another $2 per share commission. What is the cost basis, sales proceeds, and capital gain or loss?

Can you figure it out?

Capital gains can be long-term or short-term, depending on how long the security was held.

Long-term capital gains apply to securities held for longer than one year. Technically, the holding period must be one year and one day to qualify as long-term. Long-term capital gains are taxed similarly to qualified dividends: 0%, 15%, or 20%, depending on annual income.

Short-term capital gains apply to securities held for one year or less. Short-term gains are taxed at the investor’s ordinary income tax rate, which can be as high as 37% (similar to non-qualified dividends).

Capital gains and losses are reported on form 1099-B (B stands for brokerage proceeds). Each year, brokerage firms report customers’ gains and losses to the IRS. If the investor has more gains than losses (a net capital gain), taxes are owed. A net capital loss can be used as a deduction.