Understanding Tax Liability for Investments
Whether you’re investing for short term profit or long-term goals, understanding your tax liability from gains and losses can help you make better investment decisions.
Tax on investments
Tax liability from investments can typically be divided into two categories – realized and recognized. Generally, the difference between these determines whether the sale of an investment shows up on your tax returns or not. Tax liabilities can come from either gains or losses. Also, tax liabilities can be “tax-owing” (typically liabilities from profits) or “tax-benefitting” (typically from losses – or otherwise known as a “tax asset”).
What are realized gains and losses?
Realized gains and losses happen when something that you own changes in value. This can happen whether or not you actually sell an investment. Realized gains and losses can create future or potential tax liabilities or tax benefits, but these are generally not part of your current tax situation except for knowing about them and that they might affect your taxes in the future.
For example, you might own a stock that has soared in value since you bought it. If you were to sell it, you would likely have a tax liability in the year of the sale. If you haven’t sold it, you have realized an increase in value, but if you don’t actually sell it then you only have a potential tax liability. If the value were to drop to what you paid for the stock, then your realized gain drops, and so does your potential tax liability.
What are recognized gains and losses?
On the other hand, recognized gains and losses are what you usually have when you actually sell an investment for a different amount than your cost for it (more specifically, your “adjusted cost basis”). The transaction of selling converts a realized gain or loss into a recognized gain or loss. For tax purposes, most investors try to postpone the recognition of gains and the tax liability that typically goes with them while recognizing losses as soon it benefits them.
After determining whether you have a realized or recognized tax liability, often the next step is determining the amount of the tax liability. Like most things in the tax world, the answer to how much tax you will pay is – “it depends.”
When looking at taxable income and losses from investments, there are two main categories – ordinary and capital. Ordinary income from investments is typically taxed as ordinary income at the same tax rates as wages. They are considered ordinary because they don't receive extraordinary tax treatment. Certain investment income is taxed at ordinary tax rates. Examples of these include interest income from a taxable bond or bank account as well as ordinary (unqualified) dividends paid by certain investments.
Capital gains and losses typically come from the sale of capital assets such as investments, but can also come from certain distributions from these assets. One example is when you receive certain qualified dividends from a stock or capital gains distributions from a mutual fund. Certain capital income receives “non-ordinary” or special tax treatment. The most common special tax treatment is that of long-term capital gains and losses. This happens when you sell a qualified investment that you have held for more than a year. Long-term capital gains are typically taxed at lower rates than ordinary income tax rates.
In 2021, depending on your taxable income, ordinary income tax rates range from 10% to 37% while long-term capital gains tax rates range from 0% to 20%. This difference in tax rates and the resulting tax liability makes long-term capital investments especially attractive to investors.
In most situations, capital gains can be offset with capital losses. Therefore, a loss on an investment has the ability to reduce the tax liability that you would otherwise have from recognizing a capital gain in another investment. This can influence your timing of converting realized gains and losses into recognized ones.
If you have a greater amount of capital loss than you have gain, you can use up to $3,000 per year to reduce ordinary income such as wages or interest income. Any capital beyond what can be used in a tax year, can be carried over to future years to offset future capital gains and ordinary income. This benefit makes it important to manage capital losses as well as gains to minimize your tax liabilities from investments.
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