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When I started investing, I was concerned about picking the right stocks, mutual funds, and ETFs; matching any financial goals with the right asset allocation; and holding down investment fees. Those issues are important. But I also have learned not to overlook the impact of taxes on investment returns.
That said, I can’t be so concerned about taxes that I'm paralyzed from making an investment move. But it helps to consider how investment decisions impact tax liability, both in the present and for the future.
I’ll start with the main types of taxes, then explain how I may protect investing profits from taxes (no worries, I don’t know much about sophisticated tax shelters so I am going to cover the basics).
The main types of taxes with investments are 1) capital gains and 2) dividends.
Capital Gains (and Losses) Explained
Capital gains happen when I sell shares of an investment for more than I paid for the investment in the first place. What I've paid to make the purchase is its cost basis. When I sell the investment (for example, shares of the stock), my gain or loss is calculated by subtracting my cost basis from the proceeds I receive.
There are two types of capital gains or losses: short-term, which occur when I buy and sell an asset within one year or less; and long-term, which happens when I hold an asset for more than one year.
Let’s say I bought 10 shares of LinkedIn at $163 and then sold them for $233; I paid $9.95 per transaction when I bought and sold the shares. My cost basis is $1,639.95, my proceeds are $2,320.05, and my capital gain is $680.10. If I held the shares for 6 months, then I’d have a short-term capital gain. If I held the shares for 18 months, then I’d incur a long-term capital gain.
Now if I had bought shares at $233 and sold them at $163, then I'd have a capital loss.
Taxes Consequences of Capital Gains and Losses
For investments held in a regular taxable account, short-term capital gains are taxed at ordinary tax rates (currently, up to 39.6%) whereas long-term gains are taxed at long-term capital gain rates (up to 15%), which have been lower and more favorable over the past several years.
Note that I only pay taxes on capital gains when the investments are sold; unrealized or paper gains are not subject to taxation.
However, mutual funds operated by investment companies pass through realized capital gains to their investors. So, I can owe taxes on capital gains generated by my mutual funds, even though I haven’t sold shares in the mutual fund. (Note that the pass-through is one reason experts recommend purchasing ETFs instead of mutual funds.)
If I hold investments in a tax-advantaged account, such as an IRA, Health Savings Account (HSA), or 529 Plan, then my money can grow tax-free. I don’t have to pay taxes on either short-term or long-term capital gains when the investments are sold (though I may have to pay taxes with I withdraw funds).
Any investment losses (realized) can offset capital gains and ordinary income when held in a regular account. However, if investments are held within a tax-advantaged account, losses won't reduce my tax bill.
Certain investments generate dividends, which are a distribution of earnings to shareholders. I may receive these dividends as cash outright or these dividends may be reinvested to purchase more shares of the dividend-producing stock.
Dividends can be classified as qualified or non-qualified. Generally, dividends paid by U.S. corporations to stockholders are considered qualified dividends.
Mutual fund companies may pay dividends that are either qualified or non-qualified depending on how the money is generated.
Tax Consequences Associated with Dividends
Investors should receive a 1099-DIV from companies that pay dividends of $10 or more annually. The types of dividends and the dollar amount associated with each type should be indicated on the form.
Qualified dividends are taxed at capital gains tax rates whereas non-qualified dividends are taxed as ordinary income. Further, investors must hold the underlying investments for certain periods (generally 60 or 90 days) in order to receive the more favorable capital gains tax treatment.
Again, dividends on investments held within tax-advantaged accounts do not trigger immediate tax liabilities. I don’t have to pay taxes when dividends are paid to me. However, if I receive dividends in a regular account, I’ll owe taxes on the dividends even if I reinvest them and the cash never enters my checking account.
Capital Gains Tax Rate (that also affect qualified dividends)
To illustrate the difference between ordinary income tax rates and long-term capital gains tax rates, I put together this table (previous years):
See source document in PDF for more information. Note that capital gains are included in income so that gains can move you to a higher tax bracket.
Basic Actions to Consider in order to Hold Down Taxes Associated with Investing
I like to hold some investments inside of tax-advantaged accounts, particularly if I buy or sell mutual funds or stocks regularly. In this way, I can avoid taxes on capital gains and dividends while my wealth grows.
With a traditional IRA or traditional 401(k), I’ll pay ordinary income taxes when I withdraw money from the account. But with a Roth IRA, Roth 401(k), HSA, and/or 529 Plan, I can make certain qualified withdrawals tax free.
There are some advantages to holding stocks in a regular taxable account compared to a traditional IRA, depending on one's income level. For example, if I have stocks that I've held for a while and a low income, I could possibly pay 0% or 15% on the capital gain, well below the corresponding tax rate for ordinary income of 15% or 33%. However, it doesn't make sense to hang onto stock that ought to be sold just to minimize taxes.
When I have capital gains, I may try to offset gains with capital losses; that is if I have a stock that has declined in value and probably won't recover, then I might sell the shares and use the capital loss to offset capital gains on my income taxes.
I try not to go crazy analyzing tax situations of all of my investments. But it can be helpful to have a general working knowledge about capital gains and dividends and how they can affect taxes, which in turn affects investment returns, cash flow, and net worth.