Taxes pop up almost anywhere money’s involved, including when you invest. Here’s a high-level overview to give you the gist of why you might owe taxes and when.
Taxes pop up pretty much anywhere money’s involved. You owe them when you pay for stuff (sales tax), when you make money from your job (income tax), and — yep — when you invest, too.
We’re not tax pros, so we can’t tell you exactly what your tax situation will look like. But here’s a high-level overview of how taxes work when it comes to investing to help you get the gist of why you might owe them, and when.
Typically, you owe taxes whenever you’ve made money — or, in IRS speak, you’ve realized gains — from your investments. Meaning you’d owe taxes after selling an investment at a higher price than what you paid for it. (“You” is somewhat figurative here because we actually do the selling and buying for you, but more on this in a bit.)
This is the capital gains tax. Typically, your capital gains tax rate will depend on your household income and how long you owned the investment. Held onto that investment for a year or less? Then the IRS considers the money you made from selling it a short-term gain, and you’ll be taxed at your ordinary income tax rate. Depending on your tax bracket, this rate can be anywhere from 10% to 39.6%. If you held that investment for longer than a year, your profit from the sale is viewed as a long-term gain — and you’ll be taxed at a lower rate. That’s 15% for most people, though you might pay 0% or 20%; it really depends on your ordinary income tax rate.
So why would you need to sell an investment? The first reason is pretty self-explanatory — the money you’re withdrawing has to come from somewhere. To rebalance your portfolio, we buy and sell investments so that your portfolio’s asset allocation — its mix of stock, bond, and alternative funds — is where we want it to be. Market movements can shift your portfolio from its target asset allocation, so we rebalance your portfolio when the allocation strays too far. Finally, sometimes we swap out your funds for new ones because our analysis shows that the costs, risk levels, and / or diversification offer more benefits for your portfolio.
You’re also responsible for paying taxes on any income you earn in your portfolio from dividends or interest. Those are payments you get for being a shareholder, and some of the stocks or bonds that make up the funds in your portfolios pay them, which is how you end up with income.
Interest and “ordinary dividends” are taxed at your income tax rate (besides income from municipal bonds, which is exempt from federal taxes and might be exempt from state taxes depending on where you live). Meanwhile, “qualified dividends” — which have to meet specific IRS criteria — are taxed at the long-term capital gain rate.
Generally speaking: If you make any money while investing in what’s called a “taxable investment account,” you’ll pay taxes on that money when you file that year’s income tax return. So if there were capital gains from a profitable sale in your portfolio, or you received a dividend payment, or an investment you owned earned interest, you can expect to owe taxes for investments in this type of account.
Also good to know: If sell an investment for less than you paid for it (aka you had a capital loss), that doesn’t add any taxes to your bill. In fact, it could actually lower your tax bill by offsetting some of the capital gains taxes you might owe.
However, individual retirement accounts (IRAs) and 401(k)s handle taxes differently because they’re tax-advantaged accounts. A traditional IRA or 401(k) is a tax-deferred account, so your contributions may be tax-deductible — depending on your income level for IRAs— and your investment earnings grow tax-free. Then, once you’re 59½ years old, your withdrawals are taxed as income (take out money earlier, and you may be hit with an added tax penalty).
With a Roth IRA or Roth 401(k), your contributions aren’t tax-deductible, but the upside is that you don’t pay any taxes on withdrawals (again, as long as you’re at least 59½). With Roth IRAs, you also have to have had the account for at least five years when you take out money. However, if your income level is too high, you won’t be eligible to make contributions to a Roth IRA.
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