Choosing the right place to invest your money is a difficult decision even for financial experts who know the ins and outs of personal finance. It is vital to have a basic understanding of how investments work before committing any money so you can make informed choices. Stocks are a common form of investment that offer two ways for shareholders to make money: capital gains and dividend payments.
A share of stock represents a fraction of ownership of the corporation that issued it. The value of stock shares can rise and fall over time based the demand for the company's stock. When a company performs well, demand for its shares is likely to rise, leading to higher stock prices. If you buy shares that increase in value, you can sell them to make a profit or "capital gain." The possibility of making money in the form of capital gains is the primary reason people invest in stocks.
A dividend is a payment that corporations can choose to pay to stock shareholders as a means of attracting and retaining investors. Many corporations to don't pay dividends, and the ones that do tend to be large, well-established companies with steady income streams. Examples of corporations that offer dividends include McDonald's, Wal-Mart, Microsoft, Coca-Cola and AT&T. Dividends can provide a source of recurring income for shareholders even if stock prices are stagnant or fall over time.
Taxes on Stock Income
Capital gains and dividend income are subject to federal taxation. Capital gains are subject to a 15 percent tax rate if you hold an investment longer than a year and a rate equal to your income tax rate if you buy and sell the investment within a year. According to CNN, dividends are generally taxed at up to15 percent, as of 2012. The tax on dividends applies even if you reinvest dividend income. Reinvesting describes using dividends to purchase additional shares of stock instead of taking cash payments.
Although the money shareholders earn from stocks is subject to taxation, taxes can be reduced by investing through retirement accounts. When you contribute money to a 401(k) plan offered by an employer or an individual retirement account that you open yourself, the money you contribute doesn't count toward your taxable income for the year. In addition, investments in the account aren't subject to taxation until you take the money out during retirement, at which time they are subject to normal income taxes. In other words, you can avoid capital gains taxes on stock investments by contributing to a 401(k) plan or an individual retirement account.
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.