Taxable Event: An Overview
A taxable event is any action or transaction that may result in taxes owed to the government. Common examples of federal taxable events include receiving a payment of interest and dividends, selling stock shares for a profit, and exercising stock options. Receipt of a paycheck is a taxable event.
Understanding the Taxable Event
The Internal Revenue Service (IRS) rules determine which events have federal tax consequences for individuals and businesses.
Generally, taxable events must be reported by both the payer and the payee, whether or not any taxes are eventually due. For example, a bank pays interest on its savings accounts to the account holders. The bank reports the payment to the government. The account holder then reports it on a tax return. Taxes on the interest may or may not be due, depending on the account holder’s total net income.
There are several broad categories of taxable events.
Receiving Earned Income
The federal government, most state governments, and a number of local governments require businesses and individuals to pay a percentage of their earned income in taxes. A portion of income earned is withheld by the employer from every paycheck and is remitted to the government or governments.
- Taxable events are triggered by earning money, taking profits, or selling assets.
- State and local sales taxes make shopping a taxable event too.
- Taxable events can’t legally be avoided but they can be minimized by investors.
Federal payroll taxes withheld include the employee’s portion of Social Security and Medicare tax. Employers also pay a share of Social Security and Medicare taxes on behalf of each employee.
The amounts withheld are estimates of the amounts owed by an employee. At tax time, the employee submits a tax return that may result in a refund or an additional payment depending on the person’s net taxable income.
A payment of stock dividends to a shareholder is generally a taxable event.
Dividends are taxed by the federal government at various rates depending on the shareholder’s income and the type of dividends received. Ordinary dividends are taxed at a rate of 22%. Qualified dividends are taxed at the lower capital gains rates.
As of 2020, individuals with earned incomes below $38,600 do not owe federal taxes on dividends.
Making a Profit on Sale of an Asset
Capital assets such as stocks, bonds, commodities, cars, property, collectiblesand antiques generate capital gains if they are sold at a profit. Some or all of those gains are subject to taxes.
Hold onto stocks for at least a year to avoid the higher short-term capital gains tax on your profits.
To the IRS, profits from the sale of assets are either short-term capital gains or long-term capital gains, and they are taxed at different rates.
The profit earned for selling an asset that was held for less than one year is subject to the short-term capital gains tax. That tax is the same percentage as the individual’s tax rate on regular income. As of 2020, it would be 10% to 37% depending on the size of the person’s income.
Owning an asset for at least a year before selling it triggers the long-term capital gains tax, which is often lower than the individual income tax brackets. As of 2020, that means a tax of zero, 15%, or 20% will be owed on the profit depending on the person’s income tax bracket.
Sale of property such as a house or land is a taxable event but there is a big benefit for homeowners in the tax law. Individuals can exclude the first $250,000 of the gain from their taxable incomes, or $500,000 for couples who file jointly. In most cases, profit above those levels is taxable.
Buying Retail Goods
In most states and some cities, the retailer who sells goods is subject to local sales tax on most goods that are sold.
This tax is added to the customer’s bill. Every month or quarter, the seller reports the total amount collected and remits it to the government that charges it.
The amount of profit on the sale of a home that a couple can exclude from federal taxation.
In general, tangible products are taxable but services are not. Every state and locality sets its own rates, with most excluding essential goods like food from taxation.
Withdrawing Retirement Funds
Money that is saved for retirement in IRS-approved accounts such as 401(k) plans is taxable. The type of account determines when the taxable event its triggered, and what portion of the money is taxed.
In a traditional retirement account, the taxpayer pays no taxes on the amount saved at the time it goes into the account. After retiring, taxes are owed on the money saved and the profits earned as the money is withdrawn.
In a Roth account, the taxpayer pays the income taxes owed when the money goes into the account. No further taxes are due when that money and the profits it earns is withdrawn after the taxpayer retires.
An early withdrawal from a retirement account triggers a taxable event, too. That is, if a person under age 59½ takes money from the account, both income tax and a penalty will be owed. (There are a few exceptions to this rule.)
When a taxpayer converts a traditional IRA to a Roth IRA, income taxes are owed on the balance being transferred. It is added to the person’s income tax bill for that year.
Redeeming a U.S. Savings Bond
The interest on U.S. savings bonds is subject to federal tax. The taxable event occurs when the bond matures or is redeemed.
How to Minimize Taxable Events
Successful investors work on limiting their taxable events or, at least, minimizing the most expensive taxable events while maximizing the least expensive taxable events.
Holding on to profitable stocks for more than a year is one of the easiest ways to minimize the effects of taxable events, as it means paying taxes at the lower long-term capital gains tax rate.
In addition, tax-loss harvestingmeaning selling assets at a loss to offset capital gains for the same year, can help minimize taxable events.
To avoid being taxed and penalized for withdrawing from a retirement plan, employees changing jobs must directly roll over the balances in their old 401(k) plans to the new employer’s plan or to an individual retirement account (IRA). A taxable event can be triggered if that money is paid directly to the accountholder even for a short time.