Nothing good in this world comes free. Unfortunately for successful investors, that includes income and capital gains off their investments. Once you pass a certain income threshold, Uncle Sam – as always – wants his share. Let’s talk taxes for investors.
Fortunately, while tax situations can be complex, all the rules are laid out on the IRS website. And Q.ai is here to help you break them down.
When you delve into the world of investing, knowing the tax implications is essential to maximizing your gains. Each of our four common sources of investment income come with its own rules regarding tax liabilities:
The first thing to know about taxes for investors is that your tax rates will vary with your situation. At the end of the day, it all boils down to income – you’re paying Uncle Sam from your investing profits.
But how much – and when – you pay depends on the investments that generate said profits.
To that end, we’re going to focus on four common sources of investment income:
Of course, these aren’t the only sources of income in the investing world. But, for the sake of learning the basics, this will provide a solid founding on which to build a more complex understanding in the future.
So, without further ado, let’s dive in.
Tax situations in the investing world can be complex. Fortunately, taxes on interest are usually simple.
In most cases, 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 earnings in a given year.
The United States does grant a federal tax exemption in some cases, however. One such instance regards state- and municipal-issued bonds, which often don’t come with a federal tax bill. Many states also offer exceptions for various government bonds, while other securities – such as U.S. Treasuries – are always exempt from state income taxes.
Sometimes, though, bonds can come back to bite investors in the rear – such is the case with zero-coupon bonds. While investors don’t receive a payout until the bond matures, they’re required to pay taxes on annual interest calculated at the yield to maturity on the issuing date.
Dividends are payments companies make to shareholders out of their after-tax profits. Taxes on these payments can be more complex than interest-related situations, depending on the company’s status with the IRS.
Generally, you’re required to pay taxes on dividends the year that they’re received – even if you reinvest them in your portfolio. But how much you pay depends on if you’re invested in companies that pay qualified in nonqualified dividends.
Qualified dividends come from U.S.-based companies, as well as entities that have double-taxation treaties in the United States (pursuant to IRS approval).
Because these companies pay out dividends after taxes, shareholders get a small break come tax season. As a result, qualified dividends are taxed at a maximum preferential rate of 20%, although those in lower income brackets may pay 0% or 15%.
However, it’s important to note that there are qualifiers for receiving the preferential rate. For one, a shareholder must hold their position for 61 of 121 days starting 60 days before the ex-dividend date. And, if a shareholder reduces their risk via options or stock shorting, those days do not count toward the minimum holding period.
On the other hand, non-qualified dividends come from companies based outside the United States. Some U.S.-based entities may also generate non-qualified income, which will negate any preferential tax treatment.
Capital gains are the profits that result from selling your assets. These may include stocks and other securities, real estate, or even your business. In most cases, these sales generate “taxable income” according to the IRS.
Capital gains taxes can be complex in that the rates differ based on your holding period, rather than just your income.
Short-term capital gains – gains realized on sales 1 year or less from the purchase date – receive the same tax treatment as your regular income. In most cases, this tax bracket will be higher than the long-term brackets.
Long-term capital gains – gains realized on sales more than 1 year from the purchase date – are taxed at 0%, 15%, or 20%. The rate you pay depends on your total taxable income and filing status for the given year.
It’s important to note that for both long- and short-term investments, the rule for holding periods is the same as with dividends. If an investor reduces their risk of loss with options or short sales, those days do not count toward the minimum holding requirement.
Retirement accounts differ in their tax treatment to encourage individuals to save for the future. These tax-advantaged accounts allow you to invest so that you minimize your tax burden while maximizing future gains.
There are two main types of retirement accounts: 401(k)s and IRAs. While each has its own subsets with different rules and financial implications, we’re going to focus on the “traditional” and “Roth” versions.
Traditional 401(k)s and IRAs are tax-deferred accounts, which means you don’t pay taxes on contributions. You also don’t have to pay taxes on gains, interest, or dividends, so long as the money remains in the account.
But tax-deferred means that, eventually, you’ll have to pay Uncle Sam his share. When you make qualified withdrawals – typically meaning you are age 59½ or older – the money counts as regular income for that year. Thus, you’ll pay taxes in line with your current income tax bracket. However, if you take early (or even late) withdrawals, you’ll incur additional penalties.
On the other hand, Roth 401(k) and IRA contributions are not tax-deductible – so be prepared to pay taxes on the money you invest. The tax rate on these payments falls at your current income tax bracket. But, unlike traditional accounts, you won’t have to pay taxes when you make qualified withdrawals. This is what makes Roth accounts valuable to investors (as long as your income is within eligibility parameters).
No investor wants to see their profits consumed by the seemingly ever-hungry Uncle Sam. Thankfully, there are several ways to minimize your tax burden in investment situations. Though you’ll still pay out a portion of your profits, you can reduce your liability to more palatable levels.
If you’re new to the investing game, consider starting with tax-favored accounts, such as IRAs and 401(k)s. Whether you open these accounts independently or through your employer, they’re a great way to minimize your long-term tax burden.
But if you open multiple accounts, keep in mind that tax rules can vary to either your advantage or your disadvantage.
With a traditional account, you pay taxes on your withdrawals, not your contributions. Thus, if you think you’ll be in a lower tax bracket a few decades from now, traditional accounts should be your first investment.
On the other hand, with a Roth account, you pay taxes on your contributions, not your withdrawals. Thus, if you think you’ll pay less now than you will in retirement, funding your Roth account first may be to your (tax) advantage.
When it comes to capital gains, harvesting tax losses is a popular strategy to offset your burden. This process involves selling investments at a loss for the purpose of reporting said loss on your taxes.
Currently, investors can deduct up to $3,000 per year in net capital losses. (If you sustain more than $3,000 in losses per year, you can “carry forward” the loss into future tax years).
However, beware of the wash sale rule: if you sell and repurchase a “substantially identical” security within a 30-day period, any favorable tax consequences are null and void.
While international investments help diversify your portfolio, they also come with alternative tax implications. Thus, if you want to minimize your liability to Uncle Sam, consider seeking companies that pay qualified dividends. Remember, qualified dividends come with a lower preferential tax rate than non-qualified dividends.
Note, too, that you may be able to reduce your tax burden by holding nonqualified assets in a tax-deferred account. By keeping domestic stocks in your brokerage account and deflecting the bite, you may lower your tax bill overall.
It’s important to remember that how long your hold your position matters. Holding periods of less than one year often come with a higher tax bill than longer holding periods.
The same is true even of your retirement accounts. If you don’t hold off on withdrawing from your accounts until the age of 59½, the government will smack you with additional penalties.
That’s what you have to know about taxes for investors!
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