Capital Gains and Dividends are subject to a number of different tax rates. Because of this, know the rules can be a great way to cut your tax bill.
For most taxpayers, qualifying dividends are currently taxed at a maximum rate of 15%. If you're in the 10% or 15% ordinary income tax bracket, the dividend tax rate is 0%. If you're in the top ordinary income bracket of 37%, the dividend tax rate is 23.8% (20% plus a 3.8% surtax as part of the Affordable Care Act).
Regular income tax rates apply when you withdraw dividends earned within retirement accounts, such as traditional IRAs, SEPs, and 401(k)s. These rates also apply to interest income, dividends from real estate investment trusts (REITs), and many preferred stock dividends.
Short-term capital gains (assets owned for one year or less) are taxed as ordinary income. The tax rates on these investments vary from 0 to 37% prior to applying the possible surtax of 3.8% for the Affordable Care Act.
Long-term capital gains are typically taxed at 0 - 15% like ordinary dividends. However other rates apply depending on your income and the type of gain. Collectables are taxed at 28%. There is also a 3.8% investment surtax as part of the Affordable Care Act that can create a tax rate of up to 23.8% for regular long-term capital gains.
Review your investment program, keeping the following in mind:
- Consider holding stocks that pay substantial dividends outside your retirement accounts. The dividends they earn are taxed at a lower rate than they would be in the future when withdrawn from your retirement account.
- Consider holding taxable bonds and REIT shares within a retirement account, since their earnings otherwise would be taxed at the higher regular rates.
- Consider holding growth stocks that pay little or no dividends in a taxable account to enjoy lower long-term capital gain rates. However, if you trade stocks frequently or own mutual funds that trade frequently, holding them in a tax-deferred retirement account might reduce your taxes overall.
Consider your situation
The above considerations will be affected by several additional factors. Obviously, the lower rates are more significant to those with higher income. Switching your existing investments might not be the best strategy. For example, the tax consequences of pulling stocks out of your IRA probably make that move prohibitive.
The bottom line: What's good for one individual's investment style might not work for another's.
The capital gains rules can create sizable tax savings, but because of their complexity, they can also create unwanted tax obligations. If you are contemplating a major capital transaction, or if you would like a review of your overall capital gains picture, please don't hesitate to call.