DEFINITION of 'Taxable Event'

A taxable event refers to any event or transaction that results in a tax consequence for the party who executes the transaction. Common examples of taxable events for investors include receiving interest and dividends, selling securities for a gain, and exercising options.

BREAKING DOWN 'Taxable Event'

A taxable event is a transaction that triggers one or more taxes. The government has set rules in place on which events have taxable consequences for individuals and businesses. The most common taxable event is the payment and receipt of wages which are subject to income tax.

Earning wages and salaries

Federal and state tax authorities require businesses and individuals to pay a percentage of their earned income to the government. For employees, a portion of income earned is withheld by the employer and remitted to the government. The income tax withheld also includes the employee portion of Social Security and Medicare tax liable. Employers also need to pay the employer’s share of Social Security and Medicare taxes.

Receiving dividends on stocks

When dividends are paid out to shareholders, a taxable event occurs. Dividends are taxed by the federal government at a rate ranging between 0% and 20%, depending on the shareholder’s ordinary income tax bracket. In the U.S., a taxable event occurs on dividends for taxpayers in 15% and higher tax brackets.

Selling an asset for a gain

Capital assets, such as stocks, bonds, commodities, cars, properties, collectibles and antiques, etc., that are sold for a profit generate capital gains, some or all of which are taxed. Long-term capital gains – profit earned after selling an asset that was held for more than one year – are subject to capital gains tax. However, taxpayers in the lower income tax brackets do not have a taxable event when they sell an asset owned for more than a year. Short-term capital gains refer to the profit made from selling assets held for less than a year. The capital gains tax rate for short-term capital gains is usually the same as the tax rate on earned income or other types of ordinary income.

For property, a sale is a taxable event. The Internal Revenue Service (IRS) allows homeowners to exclude the first $250,000 ($500,000 for couples who own the house together and file jointly) of the gain from their taxable income, but in most cases, anything over that is taxable.

Selling and buying some types of goods

A buyer and seller are faced with taxable events in the retail space. A vendor that sells goods is liable to a sales tax. However, this tax is passed on to the final consumer through the total amount the buyer is charged. Every month or quarter, the seller reports and remits the total sales tax collected to the appropriate state government. Most tangible products are taxable, while most of the time services are not taxable. However, what products and services are and are not subject to a taxable event can vary from state to state.

Withdrawing from a retirement plan

Funds that are withdrawn from certain retirement plans, such as 401(k) plans are taxed. In addition, an individual that is younger than 59½ years old will pay an early withdrawal penalty if s/he makes a withdrawal from the account.

Redeeming a U.S. savings bond

While the interest on U.S. savings bonds received by investors is subject to federal tax, the tax is deferred until the year when the bond matures or is redeemed, at which point a taxable event occurs. Savings bonds must be held at least one year before they can be redeemed by the bondholder. If they are held for less than five years, a penalty of three months' interest will be assessed when the bonds are redeemed. This means that a bond investor will lose the last three months of interest accrued on the bond if s/he redeems the bond early.

Converting Traditional IRA to a Roth IRA

When an individual converts his Traditional IRA to a Roth IRA, he generally must pay income tax on the contributions. The taxable amount that is converted is added to his income taxes, and his regular income rate is applied to his total income.

Benefiting from loan forgiveness

When a borrower has his or her federal student loan discharged, the IRS considers the discharged amount as taxable income. In this case, the lender will issue a 1099-C Form to the borrower, indicating the amount of this discharge. This amount is considered income for tax purposes, and tax (based on the income tax bracket the individual falls into) on the forgiven amount must be paid. For example, assume a taxpayer earns $55,000 the year of her discharge and has $40,000 student loan balance discharged, she can expect to pay $8,800 (due at once) in taxes for the discharged amount. After all, debt forgiveness does not mean tax forgiveness.

How to minimize taxable events

In order to be tax-efficient, investors should focus on limiting their taxable events or, at least, minimizing high tax rate events while maximizing low tax rate ones. Holding on to profitable stocks for more than a year is one of the easiest ways to minimize the effects of taxable events, as this strategy eliminates short-term capital gains. In addition, tax-loss harvesting, a strategy which involves selling assets at a loss to offset any capital gain earned within a given tax year, can also help to minimize taxable events.

To avoid being taxed and penalized after withdrawing from a retirement plan, employees of a new firm should directly roll over old 401(k) plans to their new employer’s plan or to an individual retirement arrangement (IRA), as no taxable event is triggered for a direct rollover.

A tax advisor, accountant, or lawyer can help businesses and individuals minimize the amount of taxes to be paid to taxing authorities.


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