For most of us, simple savings are not enough to afford the lifestyle we desire now and in the future during retirement. That means that some portion of your income and savings will need to be dedicated to other investment vehicles, aside from a typical bank savings account. As those investments hopefully grow over time, Uncle Sam will want to get his share. The tax rules are complex and depend on a number of factors including the investment type, the length of time the investment is held, the type of account used to invest and the investor’s personal situation. This article will focus on the basic tax rules when investing in publicly traded instruments like stocks, bonds and mutual funds.
To optimize your after tax results and make sure you have a cohesive plan, it makes sense to have your tax advisor and your investment advisor connected and working together. “While taxes should not be the sole driver of any investment decisions, it helps us to understand our client’s overall tax situation and to be aware of timing and other factors that can help mitigate the impact of taxes,” said Chad Davis, Financial Advisor with Davis & Associates, a financial advisory practice of Ameriprise Financial Services, Inc.
Regular account or retirement (tax-deferred) account?
Depending on the type of account used for the investment, the tax rules are very different. In short, investing through a regular (i.e., not tax deferred) brokerage account means that you generally will have to pay taxes for the year of the sale on the gain realized on each investment. In simplest terms, if you buy 100 share of XYZ stock for $100 per share (total cost = $10,000) and sell all your shares later for $125 per share ($12,500 in proceeds), you have realized a gain of $2,500. That is “capital gain” subject to tax at a rate determined by your overall income and other factors.
If you invest through a tax deferred account such as a traditional IRA, SEP or 401(k), taxes are not due when you sell investments. Instead, taxes are due only when you begin to take distributions from those accounts. As a general rule, you can begin to take distributions without penalty when you reach age 59 ½, and the distribution is generally subject to your personal income tax rate then in effect. Even better, the amounts you invest over the years in many of these accounts provide immediate tax advantages. Contributions to self-employed plans, such as SEP and SIMPLE plans are deductible as adjustments to income on your tax return. A traditional IRA contribution can be tax deductible as well, depending on your situation. And contributions to employer plans, such as 401(k)s, allow you to invest with “pre-tax” dollars, meaning that you enjoy immediate tax savings on your compensation. Earnings on these accounts also grow tax-free over the years. Another option is to fund a Roth IRA or Roth 401(k) account. Roth IRA and Roth 401(k) contributions are made with already taxed money and are not tax deductible when made; however, earnings in these accounts grow tax-free too and qualified distributions from Roth IRAs and Roth 401(k)s are tax-free to the recipient.
Tax Rates on Capital Gains
Under current tax law, the amount of tax you will pay when you have taxable gain is determined by the length of time you held the investment and your ordinary income tax bracket(s). Stocks and other securities that are held for one year or less are subject to the “short term capital gain” rules. That means that these gains are treated as “ordinary income,” subject to federal tax as high as 39.6%. When the same security is held for more than one year and sold at a gain, the more favorable “long-term capital gain” tax rates apply, topping out at 20% for the highest bracket taxpayers for most investments, 15% for many taxpayers, and for some taxpayers, the applicable long-term capital gains rate is 0%. In addition to tax on profits from investments, you must also pay tax on any interest and dividends (even if reinvested) and other income you receive.
Certain high income earners may also be subject to an additional 3.8% tax on net investment income. Types of investment net income that may be subject to this additional tax include interest, dividends, certain annuity payments and capital gains. Depending upon where you live, state taxes may also apply to your investment income.
Keeping taxes down
Unfortunately, not all investments are winners. If you sell an investment at a loss, there is some benefit. You may be able to claim losses against any capital gains you have in the same year. If you have more capital losses than capital gains, you can generally claim up to $3,000 of losses against other income. If you have more than $3,000 in losses to apply against other income, you can carry over the excess to future years. Be careful of the “wash sale” rules, which can eliminate this benefit if you sell a loser and buy it back 30 days before or after the sale at a loss.
Many investment expenses may be deductible as well, including fees for investment advice and interest paid to produce taxable investment income.
“We want to coordinate with our client’s tax advisor to make sure we take full advantage of planning opportunities, as well as understanding the client’s overall tax situation. In addition, we can discuss options for timing of a sale or other transaction to help reduce the tax impact,” noted Ameriprise financial advisor Chad Davis.
Dividends and other distributions
Stocks and mutual funds often pay dividends or make other distributions. Those are also generally subject to tax in non-retirement accounts. For tax purposes, dividends are considered either “qualified” or “nonqualified.” Dividends paid on publicly traded U.S. stocks and stocks owned by qualified foreign corporations are considered qualified dividends, if certain requirements are met. Qualified dividends are taxed at the favorable long-term capital gains rates, topping out at a 20% rate for taxpayers whose income surpasses the 35% tax bracket. Nonqualified dividends do not receive this preferential tax treatment.
Distributions from mutual funds can come in many forms, including dividends (ordinary or qualified), exempt-interest dividends and capital gain distributions. Knowing which you receive is critical, as they may be taxed at different rates. Many investors automatically reinvest their dividends and capital gain distributions; as explained earlier, this income is taxable even if reinvested. The gain from the sale of mutual fund shares is also taxable capital gain, so understanding purchase dates and their basis in shares can become confusing. “Making sure the tax advisor gets the right information to prepare the tax return is important, and we try to help our clients with this when needed,” said Ameriprise financial advisor Chad Davis.
Having a holistic plan
In addition to retirement accounts, the tax law provides incentives for other types of savings. For example, health savings accounts enable individuals with certain types of high deductible insurance to save pre-tax for medical expenses. If you are saving to put a child or grandchild through college, you may be able to get tax-free treatment for earnings when paying for qualified education costs with 529 plan savings. Plus, many states provide their residents with an immediate deduction or credit on their state return for contributions made to that state’s 529 plan during the year.
“It’s important to have a plan that takes into account not just retirement savings, but other financial goals as well such as college costs and even medical expenses in retirement. We try to help our clients with all aspects of their financial lives. We enjoy working with the tax experts at Block Advisors to design a plan that addresses when and how much the client pays in taxes,” said Ameriprise financial advisor Chad Davis.
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This is just a brief overview of some tax considerations related to investments. Because the rules are complex, it makes sense for your tax advisor and financial advisor to get connected and work as a team to make sure your financial plan considers the potential impact of taxes on your investments.
Ameriprise Financial and Block Advisors are not affiliated. Block Advisors is not a broker-dealer.
Ameriprise Financial, Inc. and its affiliates do not offer tax or legal advice. Consult with your tax advisor or attorney regarding specific issues.
The initial consultation provides an overview of financial planning concepts. You will not receive written analysis and/or recommendations. Investment advisory products and services are made available through Ameriprise Financial Services, Inc., a registered investment adviser. Ameriprise Financial Services, Inc., Member FINRA and SIPC.