Ordinary Income and Capital Gains

According to an article on ordinary income and capital gains taxes, profit you make from your stock investments can be taxed in one of two ways, depending on the type of profit:

• Dividends - When you receive dividends from your stock (either in cash or stock), these dividends get taxed as ordinary income. This is also true if those dividends are in a dividend reinvestment plan. If, however, those 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. In January, investors receive a 1099-DIV statement from the issuer of the dividends that includes information on the amount of dividends earned the previous year. Check with your tax advisor because the latest tax laws offer tax advantages for dividends.

• Short-term capital gains - If you sell stock for a gain and you’ve owned the stock for just one year or less, the gain is considered ordinary income. If you buy a stock on August 1 and sell it on July 31 of the following year, that’s less than one year. To calculate the time, you use the trade date (or date of execution). This date is the date that you executed the order instead of the settlement date. 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
Long-term capital gains are usually much better for you as far as taxes are concerned. The tax laws reward patient investors. After you have held the stock for at least a year and a day (what a difference a day makes!), your tax rate will be reduced. Get more information on capital gains in IRS Publication 550 “Investment Income and Expenses”. Because the tax on capital gains is the most relevant tax for stock investors.

Managing the tax burden from your investment profits is something that you can control. 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 hold on to them at least a year to minimize the amount of taxes you have to pay on them.