Investing in stocks with gross income (not yet taxed) cash from contract work?

Question

I do side work, every year I usually have somewhere between $10,000 and $25,000 in cash. Every year I do my taxes I mark this as additional income and pay taxes on it.

This year I'm going to have an extra $5,000 from a side job. I was thinking of investing this in the stock market. What is the full lifecycle of payments that I would expect? Edit add - US tax system.

For example:

01/01/2011 - Company A gives me a check for $5000
03/01/2011 - I invest $5000 in Google
05/01/2011 - Google rises by 10% over the year
11/01/2011 - I cash out all my google stocks
11/02/2011 - I now have $5,500 in cash
03/01/2012 - I do my taxes

Do I just treat it as if I made $5500 that year? Or do I need to split these into two things?

Alternate example

01/01/2011 - Company A gives me a check for $5000  
03/01/2011 - I invest $5000 in Google
05/01/2011 - Google drops by 10% over the year
11/01/2011 - I cash out all my google stocks
11/02/2011 - I now have $4,500 in cash
03/01/2012 - I do my taxes

Do I mark it as $5,000 or $4,5000...

I'm sure this is a basic stocks question, any articles would be appreciated.

Answer 1

You should get a 1099-MISC for the $5000 you got. And your broker should send you a 1099-B for the $5500 sale of Google stock.

These are two totally separate things as far as the US IRS is concerned.

1) You made $5000 in wages. You will pay income tax on this as well as FICA and other state and local taxes.

2) You will report that you paid $5000 for stock, and sold it for $5500 without holding it for one year. Since this was short term, you will pay tax on the $500 in income you made.

These numbers will go on different parts of your tax form. Essentially in your case, you'll have to pay regular income tax rates on the whole $5500, but that's only because short term capital gains are treated as income. There's always the possibility that could change (unlikely). It also helps to think of them separately because if you held the stock for a year, you would pay different tax on that $500. Regardless, you report them in different ways on your taxes.

Answer 2

In most jurisdictions, you want to split the transactions. Why? Because you want to report capital gains on your investment income, and this will almost always be taxed at a lower rate than employment income. See Wikipedia's article for more information about capital gains.

In Canada, you pay tax on 50% of your realized capital gains. There are also ways to shelter your gains from tax; in Canada, TFSA, in the US, I believe these are 'roth' accounts.

I actually think you have to split the transactions, at least in Canada and the U.S., though I'm not absolutely sure. Regardless, you want to do so if you plan on making money with your investments. If you plan on making a loss, please contact me as I'm happy to accept the money you are planning on throwing away.

Answer 3

You need to report the income from any work as income, regardless of if you invest it, spend it, or put it in your mattress (ignoring tax advantaged accounts like 401ks). You then also need to report any realized gains or losses from non-tax advantaged accounts, as well as any dividends received. Gains and losses are realized when you actually sell, and is the difference between the price you bought for, and the price you sold for. Gains are taxed at the capital gains rate, either short-term or long-term depending on how long you owned the stock.

The tax system is complex, and these are just the general rules. There are lots of complications and special situations, some things are different depending on how much you make, etc. The IRS has all of the forms and rules online. You might also consider having a professional do you taxes the first time, just to ensure that they are done correctly. You can then use that as an example in future years.