As with nearly all other forms of income you receive, the Internal Revenue Service collects taxes on money you earn by selling an investment for more than the price for which you purchased it. This tax, called the capital-gains tax, usually can't be deferred or avoided by immediately reinvesting any gains, such as dividends or proceeds from a sale, into a similar investment. Reinvested gains alter the tax basis of the investment and, if tracked properly, can help reduce future capital-gains assessments.
Any time you purchase an item, be it a stock or a collectible comic book, and sell it for a profit, you must report the profit as a capital gain. The IRS requires you to report the tax basis -- essentially the asset's purchase price -- and the final sale price. The rate at which the IRS taxes the gains vary, with some items such as collectibles receiving higher tax rates than standard investments. Proceeds from items held for less than a year are considered short-term gains, and may be subject to a higher tax than assets held for longer periods of time, which are considered long-term gains. Generally, capital gains are often taxed at a 15 percent rate, and aren't subject to normal income-tax rates.
Immediate Tax Impact
If, like many investors, you choose to immediately reinvest gains such as dividends or proceeds from a sale into additional stock, the IRS still treats the gains as if you received the cash. Your broker or financial institution may issue a 1099-G that reports your gains; if it doesn't, you still must report the gains on your Form 1040. This amount, whether it's reinvested or taken as profit, is taxed at applicable capital-gains rates, so reinvesting the gains has no discernable tax advantages in the tax year in which you receive the gains.
Long-Term Tax Impact
If you maintain accurate records, reinvesting capital gains into an original investment alters the investment's tax basis, which potentially lowers your tax liability when you sell the asset. For example, an investor purchases 100 shares of stock worth $20 each; the tax basis on this asset is $2,000. A year later, he reinvests dividends and purchases 10 shares at the price of $21 each, and a third year, he reinvests gains to purchase 10 more shares at $25. If he holds onto the investment for another year before he sells so that all shares are taxed at long-term rates, his tax basis is $2,450, the total purchase price of the investment. A $3,000 sale incurs $550 in taxable gains. Many investors lose track of the different purchase prices, and total the sale at the price of the original investment, calculating taxable gains at $1,000.
Offsetting Gains with Losses
Instead of hoping for a capital-gains tax break by reinvesting gains, you should consider coupling capital losses with capital gains. The IRS allows you to offset your yearly investment gains with yearly losses, so coupling the sale of a high-performing investment with a failing dud can reduce your gains tax liability. The IRS only allows you to claim capital losses as an offset against gains -- they don't impact your tax situation if you don't have gains to offset -- so coupling the sale of winning investments with losing ones provides a silver lining to bad investments.
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