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The Tax Consequences of Investing

by Charles Rotblut, CFA

The Tax Consequences Of Investing Splash image

Any investment account you hold comes with tax implications. Some of these implications will be costs you incur, such as capital gains taxes, while others will be a reduction in your actual out-of-pocket expenditures, such as contributions to a tax-deferred retirement account. A basic understanding of how the tax laws impact your investments can help you make better portfolio decisions.

Tax Savings on Investment Accounts

I’ll start with the good news. The tax code is written to encourage people to save for retirement. Contributions made to a traditional IRA, a defined-contribution plan (e.g., a 401(k) plan) and similar types of tax-deferred accounts lower your tax bill in the year you make the contribution up to certain income limits.

There are two ways this occurs. If you are employed and participate in your employer’s defined-contribution plan, your contributions are taken out of your paycheck pretax. This allows a person to have his take home pay reduced by a lesser amount than he actually contributes. A couple who is in the 25% tax bracket with a combined salary of $100,000 and who contributes $10,000 in a calendar year to their 401(k) plan will see their post-federal-tax take home pay reduced by only $7,500. Why? They are only being taxed at the federal level on $90,000 of income, even though they earned $100,000.

The second is if you contribute to a traditional IRA or a similar type of tax-deferred account. Up to certain limits and subject to income restrictions, you lower your taxable income dollar-for-dollar by making an IRA contribution. For someone in the 25% tax bracket, a $5,500 contribution lowers their federal tax bill by $1,375 ($5,500 × 25%), making the actual out-of-pocket cost for the contribution just $4,125 ($5,500 – $1,375).

Taxes are due when withdrawals are made from a tax-deferred account, however, so the contributions are not permanently tax-free. A Roth IRA differs in that contributions into it are made with aftertax dollars. When you make a contribution to a Roth IRA, your tax bill for the current year is unchanged. A $5,500 contribution costs you $5,500 out of pocket. You would opt for doing this if you believe your tax rate will be higher in retirement or you want to reduce the level of mandatory withdrawals you will face in retirement.

Capital gains, interest income, dividends and distributions realized in retirement accounts are generally tax-free. If you sell a stock at a gain or receive a distribution from a mutual fund or interest from a bond in a retirement account, you most likely will not incur any taxes.

Tax Costs on Investment Accounts

Now, here’s the bad news. Income realized from investments held in taxable accounts, such as a traditional brokerage account, is generally taxable. If you sell an investment or receive dividends, interest or distributions, a taxable event is most often created.

The most commonly known of these taxable events is capital gains. If you buy an investment—regardless of whether it is a stock, a bond, or shares in a mutual fund or exchanged-traded fund (ETF)—and you sell it for more than you paid, the profit is taxable. The capital gains tax you will pay depends on how long you held the asset. Profits from investments held for less than one year are short-term capital gains and are taxed at your marginal tax rate (between 25% and 33% for most individual investors.) Profits from investments held for longer than a year are taxed at the lower long-term capital gains tax rate (15% for most individual investors). If you sell the investment for a loss, capital gains are offset. Additional losses can be deducted up to $3,000 per year.

Qualified dividends also receive preferential tax treatment. They are taxed at a 15% rate for most individual investors, as long as a consecutive 61-day holding period is met. Not all equity investments pay qualified distributions. Master limited partnerships (MLPs) and real estate investment trusts (REITs) are two examples of assets where distributions are not qualified for the lower tax rate. If you have questions about whether a dividend is qualified, contact the company’s investor relations office.

A mutual fund or an ETF may distribute both dividends and capital gains. An explanation of which distributions are capital gains and which are qualified dividends will be listed on Form-1099, which is provided by the fund company each year.

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Interest income is taxed at your marginal income tax rate. Interest income is realized from taxable bonds, money market funds, certificates of deposit (CDs), and other similar assets. Interest in municipal bonds is typically tax-free, however.

High-income earners also incur the additional 3.8% net investment income (NII) tax. This levy is charged on top of other investment taxes. It applies to, but is not limited to, interest, dividends, and capital gains realized in taxable accounts.

Taxes on Retirement Withdrawals

Once you turn age 70½, you must take a required minimum distribution (RMD) from your tax-deferred retirement accounts, including 401(k) plans and traditional IRAs. RMDs must also be taken from a Roth 401(k) plan. A penalty applies if the RMD is not taken when required.

Withdrawals from a tax-deferred retirement account are taxable at your prevailing ordinary income tax rate, which may be higher or lower than what it was when you made the contributions. The tax is applied to the amount withdrawn, not the amount contributed. So, if your $5,500 contribution grows to $20,000 and you withdraw $10,000, you will be taxed on the full $10,000 withdrawal. An additional 10% penalty generally applies to withdrawals made from a retirement savings account before age 59½.

Withdrawals from Roth IRAs are not taxable, as stated previously. Roth IRAs are exempt from RMDs as well. A Roth 401(k) plan can be rolled over to a Roth IRA prior to retirement to avoid the mandatory distributions.

Three Additional Points

Though no one likes paying taxes, taxes should never be the primary determinant of your investment decisions. When determining when to buy or sell any investment, make your decision based on the investment’s current characteristics and its appropriateness for your portfolio.

The tax code allows for considerable flexibility in what type of account an investment can be held in. This allows you to use what is known as “asset location” to your advantage. You can put the investments likely to incur the lowest tax rates and the fewest number of taxable events in your taxable accounts and those that are likely to result in the highest or more frequent tax bills in your retirement accounts. (See “Do’s and Don’ts of IRA Investing” by Robert Carlson in the March 2010 AAII Journal for information on what can and cannot be held in an IRA.)

Finally, understand that the tax code is complex. Our annual “Individual Investor’s Guide to Personal Tax Planning” (most recently in the December 2013 AAII Journal) provides a good overview of the prevailing tax rates, retirement savings account contribution limitations, and changes to the tax law. Neither it nor this article can cover every specific area of the tax code that may affect you. If you have questions about your personal situation or a specific type of investment, consult with a tax professional.

For more Beginning Investor articles, click here.

Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at twitter.com/CharlesRAAII.


Discussion

Richard Hammerness from TX posted 5 months ago:

Excellent summary and not just for the beginning investor. Who won't benefit from a quick refresher?


David Dolce from RI posted 5 months ago:

Excellent article and the ones I enjoy, review of the basic and some detail that serves as a good reminder. Really enjoy these style of article.


Barry Estell from KS posted 5 months ago:

I have discovered that under current law maximizing deferred retirement account contributions is a tax trap. Yes, it compounds tax free, but then you end up with most of your income from retirement account withdrawals being taxed at up to twice the 15% rate of dividends and capital gains. If one doesn't trade aggressively and hold stocks for the long term, one is better off with a smaller retirement account and a larger personal portfolio; with bonds in the deferred account if you still want any bonds at the current low rates.


Dave Gilmer from WA posted 5 months ago:

Barry,
I believe if you analyze the full mathematics of the tax-deferred account you will see that it will be pretty hard to beat the fact that you avoided paying maybe 25 to 33% percent tax up front, to pay anywhere from 0 tax to 15% or maybe 25% in retirement.

I actually think your best option is to "tax diversify" your holdings. This gives you the best option to "adjust" your tax-rate later on.

Dave


Dave Gilmer from WA posted 5 months ago:

Good summary of the tax consequences of investing.

I would like to stress however, that the ordinary income tax rate on retirement IRA money CAN and IS 0% in a number of cases. This can be in excess of $20,000 for a married couple both over 65 and retired with only SS income.

So when you are thinking of these options, they all have to be considered with knowledge of your own net worth in retirement, what types of accounts it is held in, and how you might be spending that money.


Roger Grossel from FL posted 5 months ago:

Good basic article on taxes.
What I see missing is coverage of the IRS wash sale rules. A wash sale occurs when you sell or trades stocks or securities at a loss and within 30 days before or after the sale you buy/acquire a "substantially identical stock or security"(or contract or option to buy such - or your spouse does). Such losses are disallowed/postponed until you dispose of the new stock or security.

I have just sent Charles a PowerPoint chart that explains this rule -I think simply- and am asking Charles to publish advice on this.


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