Almost everything you own is a capital asset, at least as far as the Internal Revenue Service is concerned. That includes your home, your jewelry, your car, your lawnmower and your investment securities. If you sell a capital asset for a profit, you have a taxable capital gain, but appreciation on a capital asset, such as a stock investment, is tax-deferred as long as you own it.
Stock represents ownership in a company, and each share of stock represents an amount of company ownership equal to every other share. Stock ownership gives you the right to participate in the company's financial fortunes. If the company earns a profit, it might return a portion of those profits back to the stockholders in the form of a dividend. If the market perceives the company to be a good investment, the market price of its stock might increase, giving stockholders the opportunity for a capital gain if they decide to sell their stock. Stock prices can also decrease, resulting in a potential capital loss.
Taxes on Dividends
Companies are not required to pay dividends and there is no guarantee that a company will pay a dividend -- even if it has a long history of paying regular dividends. The decision to pay a dividend is made by the company's board of directors. Companies that pay dividends typically do so on a quarterly basis. Dividends are taxable as income in the year you receive them. Most of the dividends paid by companies are ordinary dividends, which are taxed as ordinary income.
Any stock you own is a capital asset, just like your house and your car. Capital assets are not subject to federal income taxes as long as you own them. You only get taxed on your capital assets once you sell them. Your stocks can appreciate in value for as long as you live without resulting in a taxable event. The taxes on your stock investment are deferred until you sell.
Long-Term vs. Short-Term
You will be taxed on any gain when you sell your stock, but the rate at which the gain is taxed depends on how long you have held the stock. If you owned the stock for one year or less, the gain is considered a short-term capital gain and is taxed as ordinary income. If you owned the stock for more than one year, the gain is considered long-term and is taxed at the more favorable long-term capital gains tax rate.
Taxes are deferred on investments -- including dividends or capital gains produced by stock investments -- held in a qualified account, such as a 401(k) or an individual retirement account. Taxes on withdrawals from a qualified account will vary based on the type of account. For example, qualified distributions from a traditional IRA are taxed as ordinary income, regardless of how the money was earned. Qualified distributions from a Roth IRA are completely free from federal income taxes, regardless of how they were earned.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.