How to Avoid Overpaying Tax on Stock Investments

Make sure you’re not paying the IRS more than necessary on your stock investment gains

Even though stock investments can be risky, investors can realize pretty big returns. Most experts suggest creating a diverse portfolio of different kinds of stocks, and hanging on to them through various market fluctuations.

But keep in mind that there are certain strategies you can use to minimize the tax you pay on the returns you see. Here’s a look at how stocks earn you money and how small steps can help you avoid overpaying in taxes.

Stock basics: How you earn taxable rewards

When you own stock, you own a share or a piece of a company. Stock is then traded through a stock market exchange. You can then earn money on stock investments in the following ways:

  1. The price of a stock you own increases, and you sell it for more money than you paid for it
  2. Dividends, which are regular payments made to shareholders

Note that not all stocks pay dividends, and of course, not all stocks increase in value. But the proceeds made from rewards are taxable when they’re paid out. However, capital appreciation may be deferred until you sell, or stepped-up at your death.

Why stocks can be a tax-advantaged investment

Stocks are often considered to be tax-advantaged investments. The returns you receive on qualified corporate dividends have tax caps of 20%, which is a big benefit, considering income could otherwise be taxed at 39.6%. Qualified dividends are taxed at the capital gains tax rate, and most dividends from companies in the U.S. that operate under a standard corporate structure are considered qualified.

Long-term capital gains received from stock investments are also capped at 20%. These caps were implemented at the beginning 2013, when the “fiscal cliff” in the U.S. was narrowly avoided.

Keep in mind that if your income is greater than $200,000, or greater than $250,000 for people who file taxes jointly, you are subject to a 3.8% unearned income Medicare contribution on dividends and capital gains.

Stocks can be held in taxable or tax-deferred accounts, IRAs, or qualified plans. However, if you do keep these funds in tax-deferred accounts, qualified corporate dividends and capital gains are converted into income, which doesn’t see that cap of 20%. So, you may see a higher rate on that converted income. Plus, stepped-up gains at your death don’t apply in tax-deferred accounts.

Tax swaps

A tax swap is a strategy in which you sell a stock at a loss to receive the tax benefit on that loss, and then buy another stock that is similar, but not identical, to that stock. Losses in your investments are tax deductible, so often investors will take advantage of a loss this way. This strategy is also referred to as harvesting tax losses.

But, there are regulations to be aware of so you don’t make a detrimental mistake. The IRS prohibits what is called a “wash sale,” meaning you cannot sell your stock at a loss and then buy the same stock back right away (within 30 days before or after the sale). While it can be tricky to determine what the IRS considers to be an identical stock, risky moves could include:

  • Reinvesting in another fund in the same stock market index, like the S&P 500
  • Using an IRA, qualified plan, or trust and claiming the loss in the taxable account
  • Failing to keep an eye on accounts that have different managers

The first two examples above may appear too aggressive to the IRS.

Tax swapping, or harvesting tax losses, on the other hand, is not prohibited by the IRS, since you aren’t buying the exact same stock; only a similar stock that essentially keeps your portfolio the same as it was. You can swap with stocks, bonds, and mutual funds.

On your taxes, you can deduct up to $3,000 in capital losses against your ordinary taxable income, or $1,500 for married couples that file taxes separately. Any additional losses can then be carried forward to future years to offset income.

This is why tax-loss harvesting can be a good way to avoid overpaying tax on stock investments.

When you’re ready to take a look at your financial plan and create strategies that minimize tax and maximize returns, get in touch with our team at Provident CPA and Business Advisors. Our aim is to help you protect your assets and provide you with the advice you need to create the best portfolio for you.