Capital Gains Tax Implications
When you sell a stock you obtain a capital gain.
In order to determine the capital gains tax you are subject to you should find the difference between the price at which you have sold the stock and your basis in the stock. After deducting them you will get your profit or loss.
The basis represents the price at which you have purchased the stock. If you haven't bought the stock, but have inherited it, the price of the stock at the time the owner has died is taken as the basis.
There are cases in which the difference can be a negative number. As a result you have incurred a loss. This loss can be turned into your advantage by offsetting the capital gains taxes.
Types of Capital Gains
Basically there are two types of capital gains. The first one is short-term capital gains, whereas the second one is the long-term capital gains.
1. Short-Term Capital Gains
Capital gains of a short-term character are those that have been in the possession of the investor for less than a year. The profit that is obtained is taxed at the same rate as an ordinary income. This rate is typically 25% or more of the profit you have acquired.
As you will see in the preceding lines, long-term capital gains taxation is more favorable so we recommend the holding of a stock for more than a year.
2. Long-Term Capital Gains
Capital gains of a long-term character are those that have been in the possession of the investor for more than a year. If you fall in the 25% income tax bracket or higher you will be liable to 15% tax rate on your stock profits. If you are in the 15% income tax bracket or lower, you will be charged as little as 5%.
As you can see, Uncle Sam has a far more favorable attitude toward long-term capital gains. Therefore, we recommend the holding of stocks for more than a year.
Dividend Tax Implications
If you receive dividends from your stock you are liable to taxes. The current tax rate of 15% is about to expire in 2008. Investors hope that this rate will be renewed after it expires. If not renewed, the dividends you receive will be subject to a tax rate equal to rate you are charged for your ordinary income.
If you are unwilling to pay taxes on your dividends you can consider the option of making the stock a part of a retirement plan. You should include the option of making automatic dividend reinvestment.
Additional Tax Advices
Once you are sure that your capital gains fall in the long-term category, you can see whether you are experiencing capital losses from any of your stocks. These losses can be turned into your advantage by using it to offset any capital gains.
On the other hand, you should not get rid of a stock just because it has lost its positions and you want to offset capital gains. You may dump a stock that may provide you with profits.
The selling of losing stocks for the purposes of offsetting capital gains is one of the reasons why the market decreases with the nearing of the end of the year.
IRS's Wash Rule
Many investors have intentionally sold a losing stock in order to offset capital gains and later again purchase the same stock. As a result the IRS has taken the necessary moves to limit such practices. It is referred to as the wash rule.
The rule forbids you to sell and buy one and the same stock within a 30-day time period for the purposes of claiming capital loss. If you, however, break this rule the IRS has the right to reject the claimed by you capital loss. As a result you will lose the capital gains offset.
