When you calculate your taxable income on a tax return, the amount that you pay taxes on is less than your total annual income. The Internal Revenue service lets you reduce your total income by subtracting various expenses or "deductions," which shrinks your taxable income. Buying investments like stocks or mutual funds usually does not reduce your taxable income, but stock purchases are deductible when they are associated with retirement account contributions or charitable donations.
Stock Investment Basics
In most cases, buying a stock doesn't grant you any special tax benefits. In fact, when you sell a stock at a price that is higher than what you paid for it, you will have to pay a tax called the capital gains tax on the profit you make, even though you purchase stock with money that has already been subjected to income taxes. The short-term capital gains tax rate is equal to your normal income tax rate. Holding on to stock investments for at least a year lets you pay the long-term capital gains tax rate, which is capped at 15 percent.
Buying stock can reduce your taxable income if you first contribute the money to make your stock purchase to a 401(k) retirement plan offered by your employer. When you contribute to a 401(k) plan, the money you contribute gets deducted from your pay before you ever receive it in your paycheck. The contribution avoids taxation in the year you make it, which reduces your taxable income for that year. You do, however, have to pay income tax on funds when you withdraw them during retirement. Keep in mind that it's not your purchase of the stock with your money that creates your tax deduction -- it's the contribution to the account that does that.
Individual Retirement Accounts
An individual retirement account or IRA is similar to a 401(k) plan, but you can open an IRA yourself without an employer’s help. The IRS says that contributions you make to a traditional IRA are tax deductible if you don't have access to a 401(k) plan or some other form of salary contribution retirement plan at work. Even if you do have a plan at work, you might get a tax deduction for money you contribute to an IRA if your income falls below $90,000 if you are married filing jointly, as of 2012, or $56,000 if you are a single filer. In other words, if you buy stock through an IRA, the money you contribute for the stock purchases can reduce your taxable income. You have to pay income tax on IRA withdrawals just like you do with a 401(k) plan. A Roth IRA is an alternative type of retirement account in which your contributions are not tax deductible, so your stock purchases don't reduce taxable income, but you don't have to pay taxes on your withdrawals or investment gains in retirement.
Gifts of assets that you make to charity are tax deductible up to the fair market value of the assets. If you purchase shares of stock and give those shares to charity, you can reduce your taxable income by the value of the shares at the time of the gift. When you donate stock to charity, you also avoid paying the capital gains tax that you would have to pay if you sold the stock. Charitable donations are considered "itemized deductions" for tax purposes. When you file a tax return you can used a standard deduction granted by the IRS or the total of all of your itemized deductions. If you don't have many other itemized deductions, you might benefit more by taking the standard deduction. In this case, charitable giving won’t reduce your taxable income.
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.