You've been socking away a lot of your income into stocks and IRAs, happily watching your pile of retirement money grow. You might not have given much thought about the tax consequences, but you can be sure that Uncle Sam eventually is going to want his cut. Unless there is a federal law that exempts a particular kind of income from taxes, the IRS will take its share. That includes dividends and capital gains from your stock investments. The good news is, there are some ways to avoid, or at least delay, paying those taxes. It all depends on what kind of account you use to hold your stock investments.
Stock represents ownership in a company. If the company earns a profit, the board of directors might decide to return a portion of those profits to the stockholders in the form of a dividend. Dividends are typically paid in cash, but might be paid with additional company stock or in another form. Dividends are taxed at your ordinary income tax rate.
The price of your stock fluctuates in the open market based on a number of factors, including supply and demand. If the market price of your stock increases and you sell it for more than you paid for it, you have a capital gain. If you held the stock for one year or less, the gain is short-term and is taxed at your ordinary income tax rate. If you held the stock for more than one year, the gain is long-term and is taxed at the more advantageous long-term capital gains tax rate.
Any income produced by stock that you hold in a stock account, including dividend income and capital gains income, is subject to current income taxes. The IRS considers stock that you hold in your stock account to be a capital asset. Any increase in the value of a capital asset is not taxed as long as you own it. Stock that you hold in you stock account can appreciate in value every year for as long as you live, and you won't have to pay taxes on the appreciation as long as you own it. You only pay taxes on the appreciated value of your stock when you sell it.
You can take a tax deduction for contributions to your traditional individual retirement account, up to $5,000 annually at the time of publication. All of the investments held in your traditional IRA grow tax deferred as long as they are in your IRA. All withdrawals from your traditional IRA are taxed as ordinary income in the year you make the withdrawal. If you take a withdrawal from your traditional IRA before you reach age 59 1/2 you'll also get hit with an additional 10 percent early withdrawal penalty.
You can't take a tax deduction for contributions to a Roth IRA. All contributions must be made with after-tax dollars. Since you've already paid income taxes on those funds, though, you can withdraw an amount equal to your contributions at any time without creating a taxable event. All of the investments in your Roth IRA grow tax-free, and once they become qualified, you can withdraw the earnings on those investments tax-free. Earnings in a Roth IRA become qualified after you had a Roth account for at least five years and meet one additional qualification, such as being at least 59 1/2 years old.
- IRS: Publication 590, Are Distributions Taxable? (Traditional)
- IRS: Publication 590, Are Distributions Taxable? (Roth)
- IRS: Topic 451 - Individual Retirement Arrangements (IRAs)
- CNN Money: How Are Stocks Taxed?
- CNN Money: What If I Hold The Stocks in a 401(k) or IRA?
- IRS: Publication 550, Dividends and Other Distributions
- IRS: Publication 550, Capital Gains and Losses
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- Paying Tax on Dividends
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- "If I Buy Stock for My Roth IRA, Do I Pay Taxes on Dividends?"