Taxes on Stocks 101

A quick overview on taxation of stocks, mututal funds, and ETFs

Under normal circumstances (in a “taxable account”), you pay taxes at two different events:

A buy and hold investor of broad-based market funds (which you should do; see Bogleheads’ discussion on asset allocation) is generally going to be most concerned with dividend taxation.

Dividend taxation

Generally speaking, dividends are taxed at long-term cap gains rates (see Selling-Stock section below).

This tax can be quite large:

  • Given the information on the left, your dividends will be taxed at a ----% rate.
  • The highest tax rate is in California, where a taxpayer in the highest bracket (>$1M/year in income) pays 36.6% taxes on their dividends (20% federal, 3.8% net investment tax, 13.3% state).

Historically, the stock market has a 2% dividend yield (meaning each year, you receive 2% of your portfolio value in dividends). Assuming you reinvest these dividends, a ~30% tax is akin to paying a “fee” of ----%/year. (2% * ----%). That small number adds up over time:

  • $10,000 growing at 8%/year will be $100,000 in 30 years
  • $10,000 growing at ----%/year (6% less a ----% tax fee) will be $---- in 30 years, a $---- reduction!

Stock selling taxation

When you sell stock (including mutual funds, exchange-traded funds (ETFs)), etc. at a price higher than what you purchased it at, you pay “capital gains tax” on the difference (the “capital gain”) between the sales price and purchase price (“basis”).

If you’ve held the stock for a year, you pay long-term cap gain tax rates (less than a year, you pay higher, “ordinary” rates) on the gain. As discussed in the dividends section, your tax rate is ----%

In practice, we don’t discuss the logistics of selling stock much as:

  • It’s rarely necessary if you buy and hold index funds while you are working.
  • If you do sell, you’ll be retired and in a lower tax bracket than when you were working (perhaps ~5%).
  • If you donate stock, you don’t pay these taxes.
  • If you die, your heirs never have to pay the capital gains taxes (“basis step up”).

Subtle notes

  • You pay taxes on the aggregate capital gains less losses at the end of a tax year. The fact that you can effectively reduce gains by selling “losers” leads to a practice we’ll discuss in other posts called tax-loss harvesting.
  • Capital losses don’t offset dividends (there’s no way to escape taxes on dividends).

Tax-avoiding accounts

In both tax-deferred (IRAs, 401(k), etc.) and tax-free (Roth IRAs, Roth 401ks, 529, HSA, etc.) accounts, all investment transactions are tax-free. So:

  • All dividends are tax-free
  • No capital gains on sales

These tax-advantaged accounts are incredibly valuable because of the avoidance of these (especially dividends) taxes. See how much a Roth is worth to you!