Some people are confused about when an income investor owes taxes to the Internal Revenue Service.
You Must "Realize" Something Before Having to Pay Taxes On It
First, just so we're clear, in the United States (I can't write about tax laws in other countries), we do not owe taxes on something that hasn't happened yet.
For example, I've see people afraid that if they buy a stock and its price goes up, they'll owe taxes on the price gain.
Not so. Yes, the price has risen. That has happened. But no new money is actually in your pocket. The stock's price could go down again tomorrow.
The same is true of investing income. You do not owe taxes on stock dividends just because the company's Board of Directors declare a dividend.
You do not owe taxes on a stock's price increase until you actually sell the stock at a higher price than you bought it for. When do that, you have "realized" a gain, and owe taxes on your net profit (you deduct the broker commission and fees you had to pay to sell the stock).
You owe taxes on stock dividends effective upon receiving the money, whether it's a check in the mail, a direct deposit to your bank account or into your brokerage account.
Buying and Selling Stock for a Profit Creates a Capital Gain, Not Income
If you do buy a stock and then sell it for a profit, that profit is known as a capital gain. That's because your capital -- the amount of money investing -- increased. So you gained money from that investment.
If you buy a stock and receive a dividend check, that money is known as income.
It's not a capital gain because your capital hasn't changed. You still owe the shares of stock. You haven't sold them. You've merely received income from your ownership of those shares of stock.
This may seem like hair splitting, but it's important to your investing portfolio and to the IRS.
Dividends You Receive Because You Own Stock are Income
If you buy and then sell stock, you're left with cash. You're not invested at all.
If you buy stock, don't sell it, and then receive dividend income, you still own the shares of stock. You're still invested.
The IRS and US Tax Code Unfairly Wants More of Your Income Than Your Capital Gains
The details have changed a lot through the years, but United States tax laws generally you pay the government a higher percentage from short term capital gains (where you held the investment less than one year) than long term capital gains (where you held the investment for over a year).
Also, you must pay the IRS a higher percentage of investment income you receive than of capital gains you realize.
This is unfair for several reasons. It's unfair to have to pay taxes on dividends because the corporation already paid taxes on their profits, so it's double taxation.
And by grabbing more out of dividends paid than of capital gains realized, the government is encouraging investors to sell stock instead of holding it. This contributes to market volatility.
In a Logical World, Stock Prices Would Always Go Up as Much as Dividends Not Paid, But This is Not a Logical World
This is one reason people give for not investing for income. They say they'd rather the company keep the money and use it to grow the company, so the stock's price will go up. Then they won't have to pay any taxes until they sell it, and the capital gains rate is lower than the income rate.
That makes sense, except there is no magical long-term correspondence between companies not paying dividends and their stock price going up more than that of companies that do pay dividends.
In Fact, Upper Managements Tend to Waste Cash Instead of Creating Stockholder Value With It
In fact, statistics show a trend toward the opposite. Except during the peak of crazy bull markets such as 1999, the market prices of companies that pay dividends go up faster than the so-called "growth" stocks.
Furthermore, because they receive income from their stocks, income investors don't have to sell the shares to benefit from their investing.
You Have to Sell Stock to Benefit From Capital Gains on It
People who own stock in companies that don't pay dividends may or may not realize capital gains, but they must sell some of their shares before they can benefit from their capital gains.
Therefore, in my opinion, it's smarter to be an income investor who never has to pay capital gains taxes because they never sell their portfolio.
Author Resource:
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