Checking out the tax implications of your investments
Paying taxes on your investments
Taking your tax deductions
Investing for your retirement
After conquering the world of making money with stocks, now you have another hurdle — keeping your money. Some people may tell you that taxes are brutal, complicated, and counterproductive. Others may tell you that they're a form of legalized thievery, and still others may say that they're a necessary evil. And then there are the pessimists. In any case, this chapter shows you how to keep more of the fruits from your hard-earned labor.
Keep in mind that this chapter isn't meant to be comprehensive. For a fuller treatment of personal taxes, refer to the latest edition of Taxes For Dummies (published by Wiley). You should also check with your personal tax advisor and get the publications referenced in this chapter by either visiting the IRS Web site at www.irs.gov or calling the IRS publications department at 800-829-3676.
However, in this chapter, I cover the most relevant points for stock investors, such as the tax treatment for dividends and capital gains and losses, common tax deductions for investors, some simple tax-reduction strategies, and pointers for retirement investing.
Tip
Tax laws can be very hairy and perplexing, and at press time, the rumblings in Washington, DC, are for the potential expiration of tax cuts. Higher (and more complicated) taxes generally aren't good for stock investors or the economy at large, so give the legislative folks a piece of your mind. A good way to do this is through taxpayer advocacy groups like the National Taxpayers Union (www.ntu.org). 'Nuff said.
This section tells you what you need to know about the tax implications you face when you start investing in stocks. It's good to know in advance the basics on ordinary income, capital gains, and capital losses because it may affect your investing strategy.
Profit you make from your stock investments can be taxed in one of two ways, depending on the type of profit:
Ordinary income: Your profit could be taxed at the same rate as wages — at your full, regular tax rate. If your tax bracket is 28 percent, that's the rate at which your ordinary income investment profit is taxed. Two types of investment profits get taxed as ordinary income (Check out IRS Publication 550, "Investment Income and Expenses," for more information):
Dividends: When you receive dividends (either in cash or stock), they're taxed as ordinary income. This is true even if those dividends are in a dividend reinvestment plan (see Chapter 19 to find out more about dividend reinvestment plans, or DRPs.) If, however, the dividends occur in a tax-sheltered plan, such as an IRA or 401(k) plan, then they're exempt from taxes for as long as they're in the plan. (Retirement plans are covered in the section "Taking Advantage of Tax-Advantaged Retirement Investing," later in this chapter.) Keep in mind that qualified dividends are taxed at a lower rate than non-qualified dividends.
Short-term capital gains: If you sell stock for a gain and you've owned the stock for one year or less, the gain is considered ordinary income. To calculate the time, you use the trade date (or date of execution). This is the date that you executed the order, not the settlement date. (For more on important dates, see Chapter 6.) However, if these gains occur in a tax-sheltered plan, such as a 401(k) or an IRA, no tax is triggered.
Long-term capital gains: These are usually much better for you than ordinary income as far as taxes are concerned. The tax laws reward patient investors. After you've held the stock for at least a year and a day (what a difference a day makes!), your tax rate is reduced. Get more information on capital gains in IRS Publication 550, "Investment Income and Expenses."
Note
You can control how you manage the tax burden from your investment profits. Gains are taxable only if a sale actually takes place (in other words, only if the gain is "realized"). If your stock in GazillionBucks, Inc., goes from $5 per share to $87, that $82 appreciation isn't subject to taxation unless you actually sell the stock. Until you sell, that gain is "unrealized." Time your stock sales carefully and hold onto stocks for at least a year to minimize the amount of taxes you have to pay on them.
Tip
When you buy stock, record the date of purchase and the cost basis (the purchase price of the stock plus any ancillary charges, such as commissions). This information is very important come tax time should you decide to sell your stock. The date of purchase (the date of execution) helps establish the holding period (how long you own the stocks) that determines whether your gains are considered short term or long term.
Say you buy 100 shares of GazillionBucks, Inc., at $5 and pay a commission of $18. Your cost basis is $518 (100 shares times $5 plus $18 commission). If you sell the stock at $87 per share and pay a $24 commission, the total sale amount is $8,676 (100 shares times $87 less $24 commission). If this sale occurs less than a year after the purchase, it's a short-term gain. In the 28 percent tax bracket, the short-term gain of $8,158 ($8,676 – $518) is also taxed at 28 percent. Read the following section to see the tax implications if your gain is a long-term gain.
Tip
Any gain (or loss) from a short sale is considered short term regardless of how long the position is held open. For more information on selling short, check out Chapter 18.
Long-term capital gains are taxed at a more favorable rate than ordinary income. To qualify for long-term capital gains treatment, you must hold the investment for over one year (in other words, for at least one year and one day).
Recall the example in the previous section with GazillionBucks, Inc. As a short-term transaction at the 28 percent tax rate, the tax is $2,284 ($8,158 × 28 percent). After you revive, you say, "Gasp! What a chunk of dough. I better hold off a while longer." You hold onto the stock for at least a year to achieve the status of long-term capital gains. How does that change the tax? For anyone in the 28 percent tax bracket or higher, the long-term capital gains rate of 15 percent applies. In this case, the tax is $1,224 ($8,158 × 15 percent), resulting in a tax savings to you of $1,060 ($2,284 less $1,224). Okay, it's not a fortune, but it's a substantial difference from the original tax.
Capital gains taxes can be lower than the tax on ordinary income, but they're not higher. If, for example, you're in the 15 percent tax bracket for ordinary income and you have a long-term capital gain that would normally bump you up to the 28 percent tax bracket, the gain is taxed at your lower rate of 15 percent instead of a higher capital gains rate. Check with your tax advisor on a regular basis because this can change due to new tax laws.
Note
Don't sell a stock just because it qualifies for long-term capital gains treatment, even if the sale eases your tax burden. If the stock is doing well and meets your investing criteria, hold onto it.
Ever think that having the value of your stocks fall could be a good thing? Perhaps the only real positive regarding losses in your portfolio is that they can reduce your taxes. A capital loss means that you lose money on your investments. This amount is generally deductible on your tax return, and you can claim a loss on either long-term or short-term stock holdings. This loss can go against your other income and lower your overall tax.
Say you bought Worth Zilch Co. stock for a total purchase price of $3,500 and sold it later at a sale price of $800. Your tax-deductible capital loss is $2,700.
Note
The one string attached to deducting investment losses on your tax return is that the most you can report in a single year is $3,000. On the bright side, though, any excess loss isn't really lost — you can carry it forward to the next year. If you have net investment losses of $4,500 in 2008, you can deduct $3,000 in 2008 and carry the remaining $1,500 loss over to 2009 and deduct it on your 2009 tax return.
Before you can deduct losses, they must first be used to offset any capital gains. If you realize long-term capital gains of $7,000 in stock A and long-term capital losses of $6,000 in stock B, then you have a net long-term capital gain of $1,000 ($7,000 gain less the offset of $6,000 loss). Whenever possible, see whether losses in your portfolio can be realized to offset any capital gains to reduce potential tax. IRS Publication 550 includes information for investors on capital gains and losses.
Tip
Here's your optimum strategy: Where possible, keep losses on a short-term basis and push your gains into long-term capital gains status. If a transaction can't be tax free, at the very least try to defer the tax to keep your money working for you.
Note
Of course, any investor can come up with hundreds of possible gains and losses scenarios. For example, you may wonder what happens if you sell part of your holdings now as a short-term capital loss and the remainder later as a long-term capital gain. You must look at each sale of stock (or potential sale) methodically to calculate the gain or loss you would realize from it. Figuring out your gain or loss isn't that complicated. Here are some general rules to help you wade through the morass:
If you add up all your gains and losses and the net result is a short-term gain, it's taxed at your highest tax bracket (as ordinary income).
If you add up all your gains and losses and the net result is a long-term gain, it's taxed at 15 percent if you're in the 28 percent tax bracket or higher. If you're in the 15 percent tax bracket or lower, the tax rate on long-term capital gains is 0 percent in 2008.
If you add up all your gains and losses and the net result is a loss, it's deductible as follows: If your loss is $3,000 or less, it's fully deductible against other income. If you're married filing separately, your deduction limit is $1,500.
If you add up all your gains and losses and the net result is a loss that exceeds $3,000, you can only deduct up to $3,000 in that year; the remainder goes forward to future years.
Of course, you don't want to pay more taxes than you have to, but as the old cliché goes, "Don't let the tax tail wag the investment dog." You should buy or sell a stock because it makes economic sense first and consider the tax implications as secondary issues. After all, taxes consume a relatively small portion of your gain. As long as you experience a net gain (gain after all transaction costs, including taxes, brokerage fees, and other related fees), consider yourself a successful investor — even if you have to give away some of your gain to taxes.
Tip
Try to make tax planning second nature in your day-to-day activities. No, you don't have to consume yourself with a blizzard of paperwork and tax projections. I simply mean that when you make a stock transaction, keep the receipt and maintain good records. When you make a large purchase or sale, pause for a moment and ask yourself whether you'll have to face any tax consequences. (Refer to the section "Paying through the Nose: The Tax Treatment of Different Investments," earlier in this chapter, to review various tax scenarios.) Speak to a tax consultant beforehand to discuss the ramifications.
In the following sections, I describe the tax forms you need to fill out, as well as some important rules to follow.
Most investors report their investment-related activities on their individual tax returns (Form 1040). The reports that you'll likely receive from brokers and other investment sources include the following:
Brokerage and bank statements: Monthly statements that you receive
Trade confirmations: Documents to confirm that you bought or sold stock
1099-DIV: Reporting dividends paid to you
1099-INT: Reporting interest paid to you
1099-B: Reporting gross proceeds submitted to you from the sale of investments, such as stocks and mutual funds
You may receive other, more obscure forms that aren't listed here. You should retain all documents related to your stock investments.
The IRS schedules and forms that most stock investors need to be aware of and/or attach to their Form 1040 include the following:
Schedule B: To report interest and dividends
Schedule D: To report capital gains and losses
Form 4952: Investment Interest Expense Deduction
Publication 17: Guide to Form 1040
You can get these publications directly from the IRS at 800-829-3676, or you can download them from the Web site (www.irs.gov). For more information on what records and documentation investors should hang onto, check out IRS Publication 552, "Recordkeeping for Individuals."
Tip
If you plan to do your own taxes, consider using the latest tax software products, which are inexpensive and easy to use. These programs usually have a question-and-answer feature to help you do your taxes step by step, and they include all the necessary forms. Consider getting either TurboTax (www.turbotax.com) or TaxCut (www.taxcut.com) at your local software vendor or the companies' Web sites.
Warning
Some people get the smart idea of, "Hey! Why not sell my losing stock by December 31 to grab the short-term loss and just buy back the stock on January 2 so that I can have my cake and eat it, too?" Not so fast. The IRS puts the kibosh on maneuvers like that with something called the wash-sale rule. This rule states that if you sell a stock for a loss and buy it back within 30 days, the loss isn't valid because you didn't make any substantial investment change. The wash-sale rule applies only to losses. The way around the rule is simple: Wait at least 31 days before you buy that identical stock back again.
Some people try to get around the wash-sale rule by doubling up on their stock position with the intention of selling half. Therefore, the IRS makes the 30-day rule cover both sides of the sale date. That way, an investor can't buy the identical stock within 30 days just before the sale and then realize a short-term loss for tax purposes.
In the course of managing your portfolio of stocks and other investments, you'll probably incur expenses that are tax-deductible. The tax laws allow you to write off certain investment-related expenses as itemized expenses on Schedule A — an attachment to IRS Form 1040. Keep records of your deductions and retain a checklist to remind you which deductions you normally take. IRS Publication 550 ("Investment Income and Expenses") gives you more details.
The following sections explain common tax deductions for investors: investment interest, miscellaneous expenses, and donations to charity. I also list a few items you can't deduct.
If you pay any interest to a stockbroker, such as margin interest or any interest to acquire a taxable financial investment, that's considered investment interest and is usually fully deductible as an itemized expense.
Warning
Keep in mind that not all interest is deductible. Consumer interest or interest paid for any consumer or personal purpose isn't deductible. For more general information, see the section covering interest in IRS Publication 17.
Most investment-related deductions are reported as miscellaneous expenses. Here are some common deductions:
Accounting or bookkeeping fees for keeping records of investment income
Any expense related to tax service or education
Computer expense — you can take a depreciation deduction for your computer if you use it 50 percent of the time or more for managing your investments
Investment management or investment advisor's fees (fees paid for advice on tax-exempt investments aren't deductible)
Legal fees involving stockholder issues
Safe-deposit box rental fee or home safe to hold your securities, unless used to hold personal effects or tax-exempt securities
Service charges for collecting interest and dividends
Subscription fees for investment advisory services
Travel costs to check investments or to confer with advisors regarding income-related investments
What happens if you donate stock to your favorite (IRS-approved) charity? Because it's a noncash charitable contribution, you can deduct the market value of the stock.
Say that last year you bought stock for $2,000 and it's worth $4,000 this year. If you donate it this year, you can write off the market value at the time of the contribution. In this case, you have a $4,000 deduction. Use IRS Form 8283, which is an attachment to Schedule A, to report noncash contributions exceeding $500.
Tip
To get more guidance from the IRS on this matter, get Publication 526, "Charitable Contributions," by calling 800-829-3676.
If you're going to invest for the long term (such as your retirement), you may as well maximize your use of tax-sheltered retirement plans. Many different types of plans are available; I touch on only the most popular ones in the following sections. Although retirement plans may not seem relevant for investors who buy and sell stocks directly (as opposed to a mutual fund), some plans, called self-directed retirement accounts, allow you to invest directly.
Individual Retirement Accounts (IRAs) are accounts you can open with a financial institution, such as a bank or a mutual fund company. An IRA is available to almost anyone who has earned income, and it allows you to set aside and invest money to help fund your retirement. Opening an IRA is easy, and virtually any bank or mutual fund can guide you through the process. Two basic types of IRAs are traditional and Roth.
The traditional Individual Retirement Account (also called the deductible IRA) was first popularized in the early 1980s. In a traditional IRA, you can make a tax-deductible contribution of up to $5,000 in 2008. In addition, individuals age 50 and older can make additional "catch-up" investments of $1,000. For 2009 and beyond, the limits will be indexed to inflation.
The money can then grow in the IRA account unfettered by current taxes, because the money isn't taxed until you take it out. Because IRAs are designed for retirement purposes, you can start taking money out of your IRA in the year you turn 59½. (Hmm. That must really disappoint those who want their money in the year they turn 58¾.) The withdrawals at that point are taxed as ordinary income. Fortunately, you'll probably be in a lower tax bracket then, so the tax shouldn't be as burdensome.
Keep in mind that you're required to start taking distributions from your account when you reach age 70½, and after that point you may no longer contribute to a traditional IRA. Again, check with your tax advisor to see how this affects you personally.
Warning
If you take out money from an IRA too early, the amount is included in your taxable income, and you may be zapped with a 10 percent penalty. You can avoid the penalty if you have a good reason. (The IRS provides a list of reasons in Publication 590, "Individual Retirement Arrangements.")
To put money into an IRA, you must earn income equal to or greater than the amount you're contributing. Earned income is money made either as an employee or a self-employed person. Although traditional IRAs can be great for investors, the toughest part about them is qualifying — they have income limitations and other qualifiers that make them less deductible based on how high your income is. See IRS Publication 590 for more details.
Tip
Wait a minute! If IRAs usually involve mutual funds or bank investments, how does the stock investor take advantage of them? Here's how: Stock investors can open a self-directed IRA with a brokerage firm. This means that you can buy and sell stocks in the account with no taxes on dividends or capital gains. The account is tax-deferred, so you don't have to worry about taxes until you start making withdrawals. Also, many dividend reinvestment plans (DRPs) can be set up as IRAs as well. See Chapter 19 for more about DRPs.
The Roth IRA is a great retirement plan that I wish had existed a long time ago. Here are some ways to distinguish the Roth IRA from the traditional IRA:
The Roth IRA provides no tax deduction for contributions.
Money in the Roth IRA grows tax free and can be withdrawn tax free when you turn 59½.
The Roth IRA is subject to early distribution penalties (although there are exceptions). Distributions have to be qualified to be penalty and tax-free.
The maximum contribution per year for Roth IRAs is the same as for traditional IRAs. You can open a self-directed account with a broker as well. See IRS Publication 590 for details on qualifying.
Company-sponsored 401(k) plans (named after the section in the tax code that allows them) are widely used and very popular. In a 401(k) plan, companies set aside money from their paychecks that employees can use to invest for retirement. Generally, in 2008 you can invest as much as $15,500 of your pretax earned income and have it grow tax-deferred. Those over age 50 can contribute an additional $5,000 as a "catch-up" contribution. For 2009 and beyond, check with the IRS and/or your tax advisor.
Usually, the money is put in mutual funds administered through a mutual fund company or an insurance firm. Although most 401(k) plans aren't self-directed, I mention them in this book for good reason.
Because your money is in a mutual fund that may invest in stocks, take an active role in finding out the mutual funds in which you're allowed to invest. Most plans offer several types of stock mutual funds. Use your growing knowledge about stocks to make more informed choices about your 401(k) plan options. For more information on 401(k) and other retirement plans, check out IRS Publication 560.
Note
Keep in mind that a mutual fund is only as good as what it invests in. Ask the plan administrator some questions about the funds and the types of stocks the plan invests in. Are the stocks defensive or cyclical? (For more information on defensive and cyclical stocks, see Chapter 13.) Are they large-cap or small-cap? If you don't make an informed choice about the investments in your plan, someone else will (such as the plan administrator), and that someone probably doesn't have the same ideas about your money that you do.