The tax code is designed to encourage folks to save and invest. That’s one reason for the wide array of retirement accounts. But it also explains the preferential tax treatment given to stocks and other longer-term investments held in regular taxable accounts. That preferential tax treatment shows up in two ways.
First, if you buy, say, a stock that appreciates in value and you hold that stock for more than a year, it’s taxed as a long-term capital gain. In 2016, long-term capital gains are taxed at 20% if your taxable income is above $466,950 and you’re married filing jointly, above $441,000 and you file as head of household, or above $415,050 and you’re single. In 2017, the 20% rate applies at $470,700 if married filing jointly, $444,550 if head of household and $418,400 if single. For everybody else, the long-term capital gains rate will be 0% or 15%. That 0% rate on long-term capital gains is a handsome tax break enjoyed by those whose total taxable income falls within the 10% and 15% federal income tax brackets.
Whatever rate you pay, it should be well below the tax rate on your ordinary income. Moreover, that capital gains tax bill only comes due when you sell and realize your gain. Hanging onto winning investments in your taxable account effectively gives you tax-deferred growth, just like a retirement account.
Second, Uncle Sam rewards taxable-account investors for owning stocks that pay qualified dividends. Those dividends are taxed at the same rate as long-term capital gains. Most large U.S. companies pay dividends that are qualified, as do some foreign corporations. Real estate investment trusts typically don’t pay qualified dividends, so you’ll have to pay income taxes instead. Even if a corporation pays a dividend that’s qualified, you also need to hold the shares for more than 60 days to get the favorable tax treatment.
In addition to these taxes, you may also be dinged for the 3.8% Medicare surtax. This surtax applies to income, including investment income, of couples filing jointly with modified adjusted gross incomes above $250,000. If you file as a single individual or head of household, the surtax kicks in once your income exceeds $200,000. Thanks to the 3.8% surtax, the top federal capital gains rate is effectively 23.8%, not 20%.
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