Investors are eligible to get tax breaks on some of their investment income. In particular, long-term capital gains benefit from lower tax rates, and some dividend payments also get preferential tax treatment. However, the rules covering both types of low-tax income differ. Below, you'll find more details on how to make the most of these two types of tax-favored income.
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Long-term capital gains
When you hold investments in a regular taxable account, you have to pay taxes on any rise in their value when you sell them. The resulting profits are known as capital gains.
For tax purposes, capital gains are divided into two categories. If you own an investment for a year or less, then any profit is treated as a short-term capital gain. Short-term gains are taxed at the same tax rate as your other ordinary income, such as your wages or salary and any taxable interest income you earn.
On the other hand, if you own an investment for longer than a year, then the profit is treated as a long-term capital gain. Lower tax rates apply to long-term gains and depend on your regular tax rate. If you're in the 10% or 15% brackets for ordinary income, then you're long-term capital gains rate is 0%. For those in the 25%, 28%, 33%, or 35% brackets, the maximum capital gains rate is 15%. A top 20% capital gains rate applies to those in the 39.6% ordinary tax bracket.
The basic rule for dividends is that they're generally treated as ordinary income. However, many payouts can get favorable treatment as qualified dividends, which are taxed at the same rates as long-term capital gains.
To be a qualified dividend, there are several rules you have to follow. Qualified dividends must be paid either by a U.S. corporation or by a foreign corporation whose shares trade on a U.S. exchange or based in a country that has a tax treaty with the U.S. government. Payouts by certain types of pass-through business entities, including real estate investment trusts and master limited partnerships, typically don't meet the requirements for qualified dividends.
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In addition, for a dividend to be qualified, you have to own the investment during a certain holding period. Specifically, in the 121-day period that starts 60 days before the dividend and ends 60 days after, you have to own the securities for at least 61 days. That prevents short-term investors from buying stocks for the sole purpose of getting a tax-favored dividend payment.
Both dividends and capital gains represent valuable income. If you play your cards right, you can also turn them into tax-favored income and pay less to Uncle Sam as a result.
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