Investing, especially for newcomers, can be a scary beast. Not only do you have to learn how to navigate the market and its plethora of investment opportunities, but you have to do so without falling into the red on bad decisions – or your tax bill.
Understanding the tax implications of your investment decisions is crucial. Each common source of investment income comes with its own rules on tax liabilities:
- Traditional retirement accounts are taxed at your income bracket at the time of withdrawal, while Roth retirement accounts are taxed at your current income bracket before you contribute
- Interest is usually taxed at your current income bracket
- Qualified dividends are taxed between 0-20%, whereas nonqualified dividends are taxes at your current income bracket
- Capital gains on investments you hold less than one year are taxed at your current income bracket, while capital gains on investments you hold more than one year are taxed between 0-20%
Investment Taxes Differ
It’s important to remember that different investments generate different types of income, and for different purposes. Thus, the types of investments you choose dictate how much – and when – you owe Uncle Sam his fair share.
While there are dozens of types of investments you can make, ranging from stocks to futures, we’re going to focus on the specific sources of income. This should provide a handy guide for dipping your toe into the world of investment taxes (without overwhelming you from the get-go).
To that end, the types of investment taxes we’re going to cover include:
- Tax-advantaged accounts
- Capital gains (and losses)
Let’s start with some of the most common investments (that you may not realize are investments): your retirement accounts.
Retirement and goal-specific savings accounts are unusual because they often provide a tax break for investing – hence, why they’re called “tax-advantaged” accounts. These take several forms, but some of the most common include:
- Retirement accounts, such as 401(k)s and IRAs
- Health Savings Accounts (HSAs)
- 529 college savings plans
You can then break down each of these accounts into two categories: tax-deferred and tax-free growth.
When you talk about tax-deferred accounts, typically you’re referring to 401(k)s and Traditional IRAs. Their tax-deferred status means that you can deduct your contributions from your income in the year you invest.
This lowers your taxable income for the year while allowing you to grow your money in a retirement fund.
For instance, if you make $100,000 per year and set aside $10,000 in your tax-deferred Traditional IRA, you would only pay income taxes on the remaining $90,000.
But keep in mind that tax-deferred does not mean tax-free. With Traditional 401(k)s and IRAs, you swap paying now for later. So, when you make your first eligible withdrawal upon retirement, you’ll pay income taxes in whatever your tax bracket is that year, rather than having paid income taxes on your funds now.
Due to their tax-deferred status, these accounts are often recommended if you think that your income come retirement will be less than what you earn now, as you’ll save money on your tax bill in the (very) long-term.
Tax-Free Growth Accounts
And then we have tax-free growth accounts, such as Roth IRAs and Roth 401(k)s. With tax-free growth accounts, you pay regular income taxes on the money you contribute, rather than the money you withdraw.
So, when you get your after-tax paycheck, you may take 20% and put that money into your Roth account. You’ve already paid your income taxes, so you won’t have to pay again when you retire.
But tax-free growth accounts come with another advantage: when you make eligible withdrawals come retirement, you typically don’t have to pay any taxes – even on the money that your money earned.
That’s right! This is one time that Uncle Sam leaves your passive earnings alone. That’s why many financial advisors recommend putting as much money as legally allowable into your tax-free accounts first, and then your other tax-advantaged investing accounts.
Then, when you’ve maxed out those contributions, you can move on to making money with more traditional investments.
Taxes on Interest
Investing for retirement is crucial in the modern age for those who want to spend their golden years living off a comfortable nest egg. But when you think about making money on your investments – particularly bonds – you’re probably more concerned with your immediate interest.
Interest is the money that your money earns. So, if you put $1,000 into federal bonds in and find that your bond is worth $1,500 in ten years, you’ve earned $500 in interest. And of course, Uncle Sam will want a slice of that, too.
For the most part, the federal government treats interest on investments as if it were ordinary income. This means that you pay the same marginal tax rate on both your work and investment income in a given year.
However, the rules vary depending on the type of bond you own.
For instance, with corporate bonds, you pay taxes on interest, full-stop, whereas interest on municipal bonds comes tax-free if they’re purchased in your state of residence.
On the other hand, U.S. Treasury Issues charge federal taxes on your interest, but you get off scot-free on your state and other local taxes.
And in the case of zero-coupon bonds, investors don’t receive a payout until the bond matures – at which point you pay taxes on annual interest calculated at the yield to maturity.
Taxes on Dividends
Dividends are the payouts companies send to shareholders on after-tax profits, like a small reward for putting your money into their company. Taxes on these payments can be complex, which is why many individuals choose to hire a tax professional to wade through the mountains of intricacies involved in reinvestment decisions.
Generally speaking, though, you’re required to pay taxes on dividends in the year you receive them – even if you reinvest them. But how much you pay depends on if you earn qualified or unqualified dividends.
Qualified dividends come from U.S.-based companies, as well as entities with double-taxation treaties. Because these companies pay out dividends after taxes, shareholders get a small tax break, which means qualified dividends are taxed at a maximum rate of 20%. For individuals in lower income tax brackets, this number may be as small as 15% or even 0%.
Of course, you do have to qualify for this preferential tax rate on your qualified dividends; for instance, you have to hold your position for a minimum number of days, and you can’t reduce your risk with options or stock shorting. (See why those tax professionals come in handy?)
Unqualified dividends come from companies based outside the United States, as well as a handful of U.S.-based entities that generate non-qualified income. In these cases, you pay taxes at your normal income tax rate.
Capital Gains (and Losses)
And here, we’ve saved the best for last. Investing for retirement is important; and knowing how to navigate earnings on your money is crucial for savvy investors. But when you think about how investing will affect your taxes, you’re probably thinking more along the lines of capital gains.
Capital gains are what they sound like: the gains you make on your capital, or the money you put into investments.
Let’s say that you open a brokerage account with a big company like Fidelity and put $1,000 into NotApple’s stock. Then in six months or one year, you sell your investment for $2,000. That puts $1,000 in your pocket – until you receive the legally-mandated 1099-B form from Fidelity outlining how much you earned in capital gains this year.
But capital gains are not as cut-and-dry as your income taxes, where your bracket depends on how much income you brought in during a given tax year. Instead, how much you owe on your capital gains depends on how long you held your investment.
Short-term capital gains are the investments you hold for less than 365 days. So, if you sold your Apple stock after six months at a $1,000 profit, you would owe 35% on your investment.
Long-term capital gains are the investments you hold for more than one year. In the scenario where you hold out for more than 365 days before selling your stock for a profit, you would then pay a much lower tax rate of 15-20% on your capital gains.
And Capital Losses
Of course, Uncle Sam, for all his machination and fancy IRS forms, is not entirely heartless. One place this comes out is in the cases of capital losses.
Capital losses, again, are just what they sound like: a loss of your capital, or principal investment. In other words, if the stock market tanks, your investments may become worth less than you paid to buy them. If you choose to sell your investment at this point, your paper losses become realized capital losses.
In these situations, the IRS gives you a tax break of up to $3,000 per year on your capital losses. Of course, if you lose $3,000 on one investment and make $10,000 on another, you still have to pay some taxes – but only on the $7,000 difference.
And if you don’t make any money on your investments in a given year, you can write off that $3,000 against your other income instead.
How to Minimize Your Investment Taxes
Now that you know what you’re in for come next tax season, you’re probably wondering how you can minimize the impact of your investments on your tax bill. While you can’t get rid of your taxes entirely, you can still take steps to reduce your liability, such as:
- Starting with goal-based, tax-advantaged accounts, such as retirement accounts and 529 college savings accounts.
- Harvesting your losses by deducting up to $3,000 per year in net capital losses. If you sustain more than $3,000 in losses in a year, you can carry the excess forward into future tax years, thus reducing your burden next year, too!
- Beware the wash sale rule, which removes any favorable tax consequences if you sell and repurchase a “substantially identical” security within a 30-day period.
- Seek out qualified dividends, which carry more favorable tax allocations for retail investors.
But the most important thing you can do to minimize your tax impact is to hold your investments. Day trading may seem fun and glamorous, but your long-term returns are likely to be cut down significantly, and your short-term tax burden will be higher, as well. By holding your investments, you give the market time to work its magic with your money and seek those higher returns every investor chases.