You read in Chapter 4 about how investments can affect your taxes, and some of that information will be reviewed in this chapter. Taxes are an important consideration when you’re investing in the stock market, and you’ll need to have a sound understanding of how they can affect your investments and your bottom line.

While everyone has to pay taxes, there are techniques you can use to help you hold on to as much of your money as possible. With that accomplished, you can reinvest, or use the money to fund those goals that caused you to start investing in the stock market in the first place!

In this chapter, you’ll read about what gets taxed and at what rates, and how to minimize the taxes you’ll need to pay. You’ll also learn the importance (if you haven’t learned this already) of keeping good tax records, making sure you have all the forms and paperwork you need, and making sure you comply with all tax codes and regulations.

Whether you win the lottery, hit the jackpot in Las Vegas, or get a big bonus from your employer, you’re going to have to pay taxes on your earnings. Paying taxes is a fact of life, and, as some savvy accountants say, “proof that you made some money.”

If you’re going to invest in the stock market, you need to realize that you’ll be taxed on your earnings, just the same as if you’d won the lottery. And you should realize that those taxes could reduce those earnings significantly. Before you begin investing in the stock market, you should review the significant tax advantages associated with retirement funds, such as 401(k) plans or individual retirement accounts (IRAs). And as you’ve read previously, you should invest in any applicable retirement accounts before getting started in the stock market.

Basically, your stock market investment earnings will be taxed in one of two ways. Taxes will be at the same amount as your regular income tax rate, or at a lower rate for gains on investments you’ve held for more than a year. Having read that, it probably sounds obvious that the best thing to do is to hang on to your investments so you end up paying less in taxes. And in many cases, that’s true.

The nature of the stock market, however, necessitates that you remain attentive, nimble, and willing to take action when necessary. Certainly taxes are one factor that affects your investment. Remember, though, at any given time there could be other factors that crop up and affect the stock you hold. And sometimes, for a variety of reasons, it could make more sense to get rid of the stock while you can, even if the tax consequences are severe.

Let’s review how your stock market earnings, or capital gains, are taxed.

Capital gains taxes are incurred not only on money realized in the stock market, but from the sale of bonds, real estate, precious metals, and so forth. Not every country imposes taxes on capital gains, and for those that do, the rate varies dramatically.

Just as a sampling, Canada imposes capital gains taxes at an individual’s regular tax rate on only 50 percent of realized capital gains, with no need to pay on the other half of the earnings. France levies a flat 30.1 percent tax on capital gains; Ireland has a flat 25 percent capital gains tax; Jamaica imposes no tax on capital gains; South Africa’s capital gains tax can be as high as 50 percent; Sweden taxes capital gains at 30 percent; and Switzerland does not tax them at all.

In the United States, capital gains are classified as either long-term gains or short-term gains, depending on how long you’ve owned a stock. If you hold an investment for less a year, the gain (or loss) from that investment is considered short term. If you hold an investment for more than a year, it’s considered a long-term investment, and your gain (or loss) is considered a long-term gain.

It’s important to understand that only realized capital gains are taxed, and only realized capital losses can be deducted or netted against gains. If you just hold the stock instead of selling it at a profit or a loss, there are no capital gains or losses. The gains and losses shown on a statement are known as unrealized gains or losses. The tax consequences aren’t reported on your tax return until the stock is actually sold.

If you end up with a short-term capital gain, meaning that you sold an investment for more than you bought it for a year or less after the stock was bought, it is taxed at the same rate as ordinary income—that is, the same rate as your regular income tax rate.

If you’re in the 25 percent tax bracket, for instance, a full quarter of those short-term gains will go to the government. Instead of realizing a $1,000 gain, you’ll have to settle for $750. If you’re taxed at the 35 percent rate you’ll have to settle for just $650 of your grand. Because holding a stock short term rather than long term can significantly affect your taxes, be sure to keep careful records regarding when you buy stock, and how much you pay for it.

Long-term capital gains are a bit more interesting, and a lot easier to take than short term. Investors who are taxed at the lowest rate of 15 percent see their capital gains taxes drop to 10 percent, provided they’ve held the investment for longer than a year. If you’re in the 25 percent or higher tax bracket, your long-term capital gains are taxed at 15 percent.

A consideration to understand regarding the tax on long-term capital gains is that, at least currently, they can’t be higher than what you would pay on ordinary income. If you are in the 25 percent tax bracket, for instance, but you realize capital gains that boost your earnings into the 28 percent bracket, the gain is still taxed at your normal tax rate of 25 percent.

The taxes you don’t end up paying on long-term gains add up, making it desirable to hang on to your investments for longer than a year.

Dividends, like any form of income, are nice to get, but you’ll be taxed on them. Most dividends are considered income and taxed at an investor’s regular income tax rate. You can assume that any dividends you receive are considered ordinary or taxable dividends, unless the corporation distributing them tells you differently.

Some dividends, known as qualified dividends, are not taxed as ordinary income, but at a rate that’s typically not higher than 15 percent, your capital gains tax rate. Qualified dividends, which were established as part of the Bush administration’s tax cuts, include most dividends earned through mutual funds. Requirements concerning the length of time stock has been held also factor into whether dividends qualify as qualified dividends. The idea behind qualified dividends was to prevent the double taxation of corporate earnings. Corporations would pay tax on their profits, and then distribute dividends to shareholders, who would again pay income tax on the dividends at their income tax rates.

Dividends must meet three criteria in order to be considered qualified dividends:

President Obama signed a two-year extension of the Bush tax cuts at the end of 2010, so the reduced rate on dividends will remain in place at least until 2012.

Everyone who is successful in the stock market will have to pony up taxes to the Internal Revenue Service (IRS)—there’s just no getting around it. The trick is to understand how to hang on to as much of your gains as possible.

Some investors get so hung up on taxes that they lose sight of their investments. While taxes should be a factor in your decisions concerning your investments, you should never make decisions based solely on tax considerations. Other considerations, such as brokerage fees and transaction costs, also should be kept in mind when deciding whether to buy or sell stock. Keep careful records, and when considering a sale or purchase, assess all of the factors that will affect it before making a decision.

If you’ve realized a capital gain, give yourself a little pat on the back. The gain indicates that you did your homework and selected a sound stock that resulted in a win for you. Having said that, let’s have a look at how you can minimize the tax you’ll need to pay on that gain.

If, while realizing capital gains on one stock, you’ve realized capital losses on another, don’t despair. For one thing, you usually can deduct capital losses on your tax return, up to a maximum of $3,000 per year, lowering your yearly income, and the tax you’ll pay on it. Another good thing about capital losses is that they can be netted against capital gains, thereby lowering the amount of tax you pay on your earnings.

Let’s say you realized a $5,000 gain on a stock you sold. Once you’re done celebrating, you start thinking about the tax you’ll need to pay on it. You remember, however, the $2,500 hit you took on a stock you sold earlier in the year, and wonder if you can somehow use the loss to offset your earnings. The answer is yes. The loss will reduce your capital gains earnings to $2,500, and that’s the amount you’ll pay taxes on. This pertains to long-term and short-term losses and gains. A long-term loss can be netted against a short-term gain, and vice versa. Always check to see if losses in your portfolio can be netted against gains, and take advantage of the tax benefits you’ll get from doing so.

Another way to minimize the taxes you’ll pay is to pay attention to short-term and long-term investments, making sure to hold on to an investment for more than a year before you sell it. If you sell a stock before you’ve held it for a year, sell it after the end of the calendar year so you can delay the realization of the gain until your taxes are due on April 15—more than a year later.

Holding on to a stock for an extended period of time is generally a favorable investment strategy, as well as useful for tax considerations. Unless there is a compelling reason to unload a stock quickly, check to see how long you’ve held it. If it hasn’t been a year, and the sale will result in a short-term gain, consider holding on to it until the gain will be long term and taxed at a lower rate.

If you’re like most investors and taxpayers, you have a healthy respect for the IRS and a strong desire to not attract the attention of its agents. If you hire an accountant or tax preparer to do your income tax, the burden of the preparation is not on you, except to provide all the necessary information and documentation, and to make sure that the information on the form appears to be correct. Remember that it’s always important to verify all information. If you notice something that doesn’t look right, be sure to ask about it. Remember that someone else’s mistake could become your problem.

If you, like an increasing number of people each year, prepare your own tax form, you’re likely to feel some significant pressure to get everything correct. Using a good tax software program like Intuit’s Turbo Tax or Block Financial’s Kiplinger Tax Cut will provide a lot of useful information and guide you through the preparation of your return.

Gathering all the information and materials you need before starting on your tax return will save you time and keep you focused on the task. You’ll need to get some information from your broker to give to your tax preparer or use as you prepare your taxes.

Before you can prepare, or have someone else prepare, your individual income tax return, also known as Form 1040, you’ll need some information.

If you’ve sold stock you’ll need a Form 1099-B, which reports the date of every sale of stock, proceeds, the number of shares traded, and other information. Your broker should provide you with the 1099-B form, and will submit one to the IRS as well. You’ll need the information from the 1099-B form in order to complete a Schedule D, which will be attached to your return.

Be sure that the information on the 1099-B matches that on the capital gains and losses section of your individual income tax return, especially the total, or proceeds, or you could be inviting a tax audit. If you want, you can read a lot more about the 1099-B form (and lots of other forms) on the IRS’s website at www.irs.gov/instructions/i1099b/ar02.html.

If you’ve received dividend income, you should get 1099-DIV forms from each company that paid the dividends. You’ll need to add up all the dividend amounts received from these forms and then report your dividend earnings on your individual income tax return. If you’ve received more than $1,500 in dividend income, you’ll need to detail your earnings on Schedule B and attach it to your tax return.

A form 1099-INT reports any interest income you might have received during the year. Information from this form also must be included on your tax return. You may also receive bank statements containing investment information, and some brokerage firms provide tax-related information to clients as well.

According to the IRS, a high percentage of completed tax forms contain mistakes. This isn’t referring to intentional misinformation, just good old-fashioned mistakes. Regardless of whether you prepare your own tax returns or have someone else do them for you, be sure to look them over carefully before submitting them.

It’s a good idea to complete the forms and then let them sit for a day or two before going back and giving them a careful check. And be sure to give yourself enough time to complete the forms without having to rush at the last minute, increasing the likelihood of mistakes. Making sure that you have all the necessary information, staying organized, and leaving enough time will ensure that you remain on the up and up with the IRS and save yourself some potential problems.

While it’s important to remain in strict compliance with IRS regulations, it’s also important to take advantage of the tax breaks that are available to you. Some expenses related to your investments can be deducted from your income taxes. You’ll need to itemize the expenses on Schedule A and attach it to your 1040.

The IRS Publication 550, Investment Income and Expenses, provides a lot of information about expenses that can be deducted, what’s considered taxable income, and so forth. You can access it on the IRS website at www.irs.gov/publications/p550/indes.html. Let’s take a look at some deductions to which you may be entitled.

Nobody wants to pay more taxes than are necessary, and being aware of deductions to which you may be entitled can help keep your tax bill to a minimum. Consider the following possible deductions:

Remember, though, that a charity has to be approved by the IRS before you can claim a deduction if you donate stock. And the Obama administration’s proposed budget for 2012 limits the value of deductions for charitable gifts for some people, so be sure to do your homework if you’re thinking about donating some of your stock to charity. More information about these deductions and which charities are IRS approved can be found on IRS Publication 526, Charitable Contributions. You can find it online at www.irs.gov/publications/p526/ar01.html.

While this book is about stock market investing, it would remiss not to remind you of the advantages of tax-sheltered retirement funds, such as 401(k)s and IRAs. With these funds, you don’t have to worry about tax factors because your investments aren’t taxed until you make withdrawals from the accounts. These are called tax-deferred investments, and it means that your money grows and you’re not taxed on your earnings until you take them out of the fund.

There are several types of IRAs in which you can deposit up to $5,000 a year, and you can stash up to $15,500 in a 401(k). These types of investments can be extremely beneficial from a tax viewpoint and are worth investigating with a financial advisor or tax preparer.

The Least You Need to Know