If you’re just getting started with investing — or if you simply need a refresher — knowing the basics of tax management for your portfolio is critical. We’ll look at a variety of tax-related questions related to the most common types of portfolio income, and we’ll also explain how taxes work for 401(k)s and real estate. 1. Taxes on dividends
What are dividends?
Companies have the option of either reinvesting excess capital into new, profitable projects, or returning money to shareholders in the form of dividends .
Dividends tend to be a sought-after form of income due to their passive nature. Shareholders receive dividends on a monthly, quarterly, or semi-annual basis without any action. That is, you don’t need to do anything to receive dividends other than be a shareholder.
Not all stocks pay dividends, but many do. Many value stocks , such as banks and utilities, pay consistent dividends that may increase over time. Growth stocks pay little or no dividends since more capital is devoted to new ventures with high expectations. Much of the tech sector is made up of growth stocks. How it works
When you own shares of stock, you’re eligible to receive dividends if the underlying company pays them. If you own dividend-paying stock, you automatically receive a dividend when a company declares one.
When you receive a dividend, you have the option to take the money in cash or reinvest your dividends back into the security. If you rely on dividend income to pay bills or to pay off debt, you’ll want to take the dividends in cash. If you’re investing for the long term, setting your dividend option to “reinvest” can help you harness the power of compound interest at an even greater rate. Minimizing taxes on dividends
When you’re paid a dividend, you’ll be liable for income tax whether you receive the dividend in cash or reinvest it. If you hold your dividend-paying investments in a regular taxable brokerage account, you will be taxed every time you receive a dividend. This is the very nature of a “taxable” account: Income accruing to your positions is taxed as it is received.
However, your dividends would be shielded from tax if you were to hold your dividend-paying investments in a tax-deferred account, such as a 401(k) or IRA , or a tax-exempt account, such as a Roth IRA .
In tax-deferred accounts, you won’t pay taxes on dividends as they’re received. You’ll only owe tax when you withdraw the money, ideally in retirement. In tax-exempt accounts, you won’t pay taxes as you receive dividends over the years, nor when you withdraw the money later on, because you pay taxes on the money before you invest it.
Another way to minimize taxes owed on any dividends received is to ensure that you hold your underlying positions for a specified period of time, which varies from security to security. If you’ve met the holding period requirements, your dividends will be treated as qualified dividends , which entitles them to preferential tax treatment.
Qualified dividends are taxed at the same rate as long-term capital gains, with tax rates ranging from 0% to 23.8%, depending on your total taxable income for the year.
To receive qualified dividend treatment, you must have held an underlying stock position for at least 61 days out of the 121-day period that begins 60 days before the ex-dividend date .
While the specific rules can be a lot to digest, the basic guidance is to hold your positions for as long as reasonably possible. Doing so helps ensure any dividends will be considered qualified. Image source: Getty Images. 2. Taxes on capital gains
What are capital gains?
Capital gains arise when you sell a stock for more than you paid for it. In an extremely simple example, if you bought a stock at $10 per share and sold it for $20 per share, you’d have a $10 capital gain.
There is a difference between realized capital gains and unrealized capital gains. Realized gains occur when you “lock in” the gain on your position by selling out of it. Realized capital gains are also officially “income”, and you’ll need to pay taxes as a result.
Unrealized gains — also known as “paper gains” — exist when you have a gain but do nothing in response. As long as you don’t sell any shares, you won’t be taxed at all on unrealized gains. How it works
As mentioned above, you don’t have capital gains income until you sell the investment that’s gone up in value. […]
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