Why Taxes Matter for Investors

When you evaluate your investments, you should factor tax liability into the mix. The date when you cash in an investment (or take a partial withdrawal) can affect how much you pay in taxes on any gains, including the tax rate. When you file your taxes after the end of that year, your total tax liability as determined by the IRS is based on both your ordinary income and your investment income. Taking a withdrawal or selling an investment at a specific time could push you into a higher tax bracket, increasing the amount of tax you pay. By comparison, strategically timing your investment income can help you minimize your tax burden.

Tax strategies for investments can feel overwhelming, but making beneficial decisions may not be as complicated as you think. With this guide, you’ll understand how investments are taxed, gain insights into taxation rates for different types of investments, and discover a few strategies from Portfolio Advisors to make the most of your investment income.

Ordinary Income vs. Investment Income

When you fill out your tax forms, you’ll separate your income into different categories. Most people will have ordinary income, which includes regular wages, tips, and interest on savings accounts. You may also have investment income, in the form of dividends and/or capital gains.

Ordinary income typically gets taxed at your ordinary income tax rate based on IRS tax tables. The U.S. uses a progressive tax system, meaning the rate rises as your income increase. Most people fall in the 12%, 22%, 24%, or 32% tax bracket.

Investment income may be taxed at a different rate depending on the type of income. Long-term capital gains are taxed at favorable rates. For example, if you sell an investment property after owning it for five years, you may pay a lower tax rate than if you sell it after owning it for less than one year. If you have an investment that pays dividends, they are broken down into qualified or non-qualified, depending on the issuer, the type of stock, and how long you have held it. It’s thus important to keep records about your holdings and when you take cash out, complete a sale, or collect a dividend, because the amount and timing can affect the tax you pay. Efficient investment management and correctly determining the income category can ensure tax filing accuracy, and it may also minimize your risk of an audit.

How Dividends and Interest Are Taxed

Interest income is typically taxed at your marginal tax rate, like your ordinary income. Investment vehicles that provide interest include savings, certificates of deposit, bonds, fixed annuities or certain insurance-related interest credits. Some of these investment vehicles require you to pay taxes on the interest in the year you earn it, while others may offer tax-deferred options on which you taxed only after the investment reaches maturity.

Dividend taxation is divided into two classes: qualified and non-qualified. Qualified dividends are tax-advantaged, which means that you may pay less than your marginal tax rate. Non-qualified dividends are taxed at your ordinary income rate, and higher-income taxpayers may also owe the 3.8% Net Investment Income Tax (NIIT). Qualified dividends must meet these requirements:

• Issuer: U.S. corporation or qualified foreign issuer must pay the dividend.
• Not Excluded: Many dividends from REITs, money-market funds, and tax-exempt entities do not qualify, although certain REIT dividends may receive a 20% deduction under the qualified business income (QBI) rules even though they are taxed as ordinary income.
• Holding Period: You must hold the dividend-paying stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (or 90 days during a 181-day period for certain preferred stock).

Timing the purchase and sale of your investments can help you maximize the benefits you get from the holding period, even if you plan to reinvest the dividends. Pay attention to the ex-dividend date for the stock before you decide to buy, especially if you plan to sell early.

Capital Gains Tax: Short-Term vs. Long-Term

When you sell an investment, you may need to pay a capital gains tax on the appreciation in value. The amount you pay depends on the type of investment, how long you held it, and your marginal tax rate. Short-term capital gains involve the sale of assets you held for a year or less. For example, if you buy crypto assets and sell them in six months for a profit, you will likely pay your ordinary income tax rate for the gain.

Long-term capital gains are taxed differently. The tax rate on long-term capital gains is 0%, 15%, or 20%, depending on your taxable income. Capital gains tax on investments is different from capital gains you might pay for your home. When you sell your home, you may be able to exclude up to $500,000 of the gain from your taxes, depending on the type of sale, how long you lived in the home as a primary residence, and whether you file separately or jointly. Most investment gains cannot be excluded, but certain asset types (such as collectibles, small-business stock, and real estate with depreciation recapture) may be taxed at rates different from the standard long-term capital gains brackets.

Taxation of Retirement Accounts & Tax-Advantaged Vehicles

Tax-advantaged vehicles like a retirement account can be a great way to reduce or defer your tax liability, but the right one depends on your goals. 401(k)s and traditional IRAs allow you to set aside a portion of your income on a pre-tax basis. This means that the money is either withheld from your income before your taxes are assessed, or you can claim a deduction for it on your tax form. These investments have strict contribution limits each year that increase once you reach age 50. HSAs also allow you to save money for medical expenses from your pre-tax income. By comparison, Roth IRAs involve investing after-tax income to avoid paying taxes on gains once you reach certain requirements.

Some retirement accounts, including 401(k)s and most IRAs, require you to take a minimum distribution once you retire or reach age 73. You’re not required to take any distributions from Roth IRAs. You can usually roll over retirement accounts into other retirement vehicles, but changing types affects tax liability. If you decide to convert a traditional IRA to a Roth IRA, for example, you’d have to pay taxes on the amount you convert in the same year.

Tax Loss Harvesting & Other Portfolio Techniques

Forming a strategy can help you influence how much you pay in taxes each year. Common strategies include asset location, tax-loss harvesting, deferring gains, or timing the sale. When you expect big gains and you want to minimize your taxes on those returns, consider asset location. Asset location involves putting high-earning investments in tax-advantaged vehicles, usually deferred-tax retirement accounts.

If you have capital gains that could significantly increase your tax liability, selling some unproductive investments at a loss could help you balance out the sheet. You can even use capital gains losses to offset your ordinary taxable income by up to $3,000 each year, including previously accrued losses. You could also defer your capital gains tax by investing immediately into something new. If you plan to sell an investment property, putting the gains into another investment property and filing a 1031 exchange can allow you to defer the tax on those gains.

Ultimately, the best way to get the most from your investments is to strategically time the sale as part of your financial planning. Consider waiting to sell large assets until you have a year with losses or other situations (like lower income) that help you reduce your overall tax burden.

State and Foreign Tax Implications

Although much of your concern may surround your payment to the IRS, you should also consider state and foreign tax implications. States set their own tax rates. Many states (including California) tax capital gains as ordinary income, while others (such as Nevada) do not levy a state income tax. Your effective state tax depends on your state residency rules and the source of the income. Even if you live in a state that does not tax ordinary income, you should determine the rules for taxes on capital gains or dividends. New Hampshire does not tax wages or capital gains, but it does tax interest and dividends at the state level.

Effective tax strategies regarding holdings on foreign investments also require some research and careful planning. Foreign investments often involve withholding taxes from the foreign country, but U.S. investors can typically use the foreign tax credit (and applicable tax treaties) to avoid double taxation. Certain investments, such as foreign mutual funds or partnerships, may have complicated tax rules that disadvantage investment from U.S. investors.

Enhance your Investment Strategy With Portfolio Advisors

Choosing the right tax strategy for your investments requires you to understand the types of investments you have and the tax impact. You’ll have different tax scenarios for short-term or long-term capital gains, as well as withdrawals (distributions) from a traditional or Roth IRA.

Navigating the tax environment for your investments starts with an evaluation of your current income, investments, and financial goals. Are you looking to maximize your gains as much as possible, regardless of the tax liability? Do you need to find ways to minimize your tax burden for a particular year in which you anticipate a big gain? You’ll need different strategies to achieve these goals.

Talk to Portfolio Advisors for a comprehensive analysis of your investments and recommendations for your financial plans. We can show you when you should hire a tax professional, how to optimize your returns, and ideal strategies to improve your financial future.

Disclosures: This material is for informational purposes only and should not be considered investment advice. Past performance is no guarantee of future results. Investing involves risk, including the potential loss of principal.