Warrior Trading Blog

Taxes on Stocks: Everything You Need to Know

Taxes on Stock

Taxes on stocks can be complicated but knowing the basics will help you be better prepared for the tax season that is right around the corner.

If you’re interested in a guide specific to day traders then make sure to check this article out!

Taxes on Stock Guide

Look back over the past ten years there have been relatively few investment opportunities in any financial market that have yield so much positive return than the US stock market. And except for Bitcoin, perhaps the most significant investment opportunity of the past decade has been in the stock market.

From January 2009 to the present date, the S&P 500 has returned over +250% – a shocking and fantastic return. In that same time frame, Gold has risen only +71%, oil a paltry +23.75%, and the DXY (Dollar Index) nearly +18%. And unless something drastic changes, this will be the first decade in 170 years that the US did not fall into a recession.

The old 60% stocks, 40% bonds have been a losing ratio compared to much higher concentrations in stocks. With the majority of the world’s central banks turning to real and unrealized negative interest rates, where do you go for growth? The same place people have gone for centuries: the stock market.

Stocks are perhaps the most well known of all financial markets. When people mention the words ‘investing’ or ‘trading,’ people naturally think of stock markets (also called equity markets). Like any financial market, stocks have their positives and negatives associated with their market.

There are also some elements of stocks that are not present in other financial markets. Stocks differ from derivatives markets like Futures or Options in that shorting stocks is not as straightforward or as available in other markets. Another great benefit that is almost singular to stocks is in the form of dividends.

Not only can you hold onto a company for the long haul, but many companies entitle stock owners to a share of the profits in the form of dividends. Stocks are one of the few financial instruments where you can invest over the long term while also creating a consistent passive income stream.

But selling a stock for more than you bought creates a capital gain – you’ll be on the hook to the taxman for those gains. The same goes for any dividends you earn.

Capital Gains Taxes on Stocks

Whenever you sell a stock for more than you bought it, you are on the hook to the taxman for that gain. It’s important to know that the Tax Cuts and Jobs Act has changed how capital gains are taxed. Tax brackets are no longer used – instead, your capital gains tax rate is attached to your taxable income.

2019 Long-Term Capital Gains Rates
Filing Status 0% 15% 20%
Single $39,375 $39,376 – $434,550 +$434,550
Head-of-Household $52,750 $52,751 – $461,700 +$461,700
Married Filing Jointly $78,750 $78,751 – $488,850 +$488,850

One of the primary considerations with capital gains is the length of time you hold stock. If you sell any stock that you’ve held for less than one year, then that sale (if there’s profit) is considered a short-term capital gain. In a nut-shell, short-term capital gains get taxed as ordinary income with rates up to +37%.

Long-term capital gains are taxed up to +20%. It is essential to understand that the one-year rule for determining a capital gain is not a calendar year, but a year from the date of purchase. The capital gains tax will always be a contentious issue from a political point of view, but thankfully it is a little bit more simplified.

But the simplification of finding your tax burden with capital gains pales in comparison to the various tax issues involved with dividends.

Dividends

Due to America’s preference for growth stocks, less firms pay dividends nowadays. Of the firms that still do return cash to shareholders, most do it through share buyback programs, which are taxed more favorably.

Some companies, not all, issue regular dividends to their owners – the shareholders. As a shareholder, you get a little cut of the profit based on the companies performance. I like to think of dividends as a sort of return on a loan. They are also paid monthly or quarterly – most pay quarterly, some even have special distribution periods.

Depending on your investment style or financial needs, dividends are going to play a significant role in your portfolio diversification.

I think most people are knowledgeable about the dividends that get distributed by some of the more popular and famous companies like Microsoft. Microsoft issues a quarterly dividend with an annual yield of roughly 1.3443%. But then you get into different and unique classifications of stocks (popular with income-seeking investors) that have their special dividend regulations: BDCs and REITs.

Special Dividends

BDCs and REITs are companies that attract people like me: monthly income streams. BDCs and REITs have substantial dividend returns compared to ‘normal’ stocks – it’s not uncommon to see a BDC have an 8% dividend yield or a REIT with a 5% yield. Many are familiar with REITs, Real-Estate Investment Trusts.

The SEC has what is known as the ‘90% Rule’ for REITs. For a company to qualify as a REIT, the bulk of its assets and income must be connected to real estate, and 90% of the taxable income must be distributed annually to shareholders in the form of dividends.

BDCs, or Business Development Corporations, are some of my favorite income-generating stocks. BDCs are best described as venture capital and specialty finance corporations. One of the most popular liked and disliked BDCS, PSEC (Prospect Capital), has an 11.02% dividend rate. PSEC issues a monthly dividend in the amount of $0.06 per share. If I had 1,000 shares of PSEC ($6,540.00 at $6.54 per share), that means I get a monthly dividend of $60.

But high dividend yields should be scrutinized. How sustainable is a +20% dividend yield? How viable is an 8% yield? What is their historical payout rate? BDCs and REITs are not without their risks, and a significant amount of due diligence is required when investing in these income earners. I actively manage my own portfolios, and I keep up to date on any filings from the companies I hold, but not everyone wants to go through that tedious process.

We should also understand that high yielding stocks don’t experience the same growth of their stock that others do.

For example, PSECs stock price has risen +3.97% from the beginning of 2019, while NVDA (NVIDIA) has gained a staggering +67.90%. So while an 8%+ yield is appealing, it should match your investment goals and your risk management plan – many a person has been led astray by the lure of high dividend yield. Including yours truly.

Regardless of your goals regarding dividends – you will need to pay the taxman on your dividends.

Dividends and Double Taxation

Lots of investors prefer companies to buy back their own shares in the open market rather than pay a quarterly dividend. This is because dividends are taxed twice. Once as taxable income at the company level, and again as capital gains at the investor level.

When a company buys back its shares, they retire those from their shares outstanding, making each share worth more, which will lead to price appreciation. This appreciation is only taxed once, which is why activist investors regularly lobby for companies to cut their dividend and begin buying back shares.

Taxes on Dividends

Welcome to confusion land. Qualified dividends, ordinary dividends, non-qualified dividends, income. There are two types of dividends: Ordinary Dividends and Qualified Dividends. Ordinary dividends are what most people are familiar with – these dividends are paid from preferred or common stock.

For example, when Microsoft (MSFT) pays a dividend to shareholders, it’s an ordinary dividend. Ordinary dividends are taxed at your income rate. Qualified dividends are still normal dividends, but they meet specific requirements to be imposed at the long-term capital gain rate.

Dividend Tax Rate
Ordinary Dividend Ordinary income tax rate, up to 37%.
Qualified Dividend Long-term capital gain rates (0%, 15%, 20%)

 

Some of the confusion of how your dividends will be taxed can be exacerbated depending on the type of stock you own. I previously mentioned BDCs and REITs as having a special kind of status and specific rules for their classification. The distributions are the same.

When BDCs distribute funds, there are up to four different taxes on the four different ways that distributions are paid (return of capital, capital gains, income, or dividends). Not all BDCs issue the same percentage of ordinary and qualified dividends, so due diligence is certainly required. These are questions best left with your financial advisor/planner. Pro-tip though: keeping all of these in an IRA or 401k reduces the taxman’s impact.

Final Thoughts – Taxes on Stocks

It’s clear that there are significant tax advantages to holding stocks for the long-term – especially when we consider the rates for short-term holds. It’s also clear that the role that dividends play is influenced heavily by your investment goals and outlook.

There is a stark difference between the marginal yield offered by a company like Microsoft vs. the income-generating risks and opportunities provided by BDCs or REITs. It can seem very overwhelming when you start to talk about the taxes involved with the selling of stocks for profits and the collecting of dividends.

Thankfully, the headache is mostly taken care of by brokers. Most modern brokers automatically tabulate and organize this information for you and can automatically be connected to some tax preparation software like TurboTax. This makes the process significantly more transparent and easy from a compliance point of view and undoubtedly less stressful and convenient from a sanity point of view.

It doesn’t make the kick that taxes take out of you any less, but you might put fewer fists through your walls with how easy it is to connect a broker to TurboTax and let them do the heavy lifting of organizing and filing all of your required tax forms.

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