As an investor, you need to understand the impact of taxes. The taxes owed on investments depend on the type of investment account. For tax-deferred accounts, such as 401(k)s and 403(b)s, you contribute money from your paycheck before it is taxed, known as “pre-tax dollars.” In other words, you do not pay taxes on the portion of your salary that goes directly into your 401(k) or 403(b). Moreover, you do not pay taxes on the income or capital gains generated each year. Instead, you pay taxes when you withdraw money from the account. Roth IRAs and college savings plans, such as 529s, are examples of tax-advantaged accounts. You fund these kinds of accounts with after-tax dollars, and you do not get a tax break upfront. After you fund a Roth IRA or 529, the income, appreciation, and withdrawals are tax-free.
For taxable accounts, income and capital gains are not tax-exempt or tax-deferred, so you owe taxes each year. Tax efficiency means that you are managing a taxable account in a way that minimizes the taxes owed each year. For any investment, the tax treatment for income and gains depends on several factors.
- A capital gain or capital loss is the difference between the cost basis of an investment and what is received when you sell it. Remember that the cost basis is the original amount paid for an investment plus or minus any adjustments to the initial cost that occur while you hold the investment. For assets that have appreciated, you pay taxes on capital gains when you sell the asset. There are some important considerations to keep in mind for taxes on investment gains and losses. Short-term capital gains occur when an appreciated investment is held for one year or less. Long-term gains occur when an appreciated investment is held for at least one year plus one day. Tax rates for short-term gains are much higher than they are for long-term gains. Short-term gains are taxed as ordinary income at a rate that can be as high as 37 percent, depending on your tax bracket. Ordinary income is the tax rate that you pay on your wages or salary and interest and other sources of income. Depending on where you live, state taxes may also apply.
- When investors take or realize a loss on an investment, they can use that loss to offset some or all of the capital gains they have realized on other investments. As an investor, you should keep track of gains and losses as you incur them and try to offset your gains with losses, particularly as year-end draws near. It is also possible to carry losses forward to offset gains in the future. The amount of losses that you can carry over each year, however, is limited. You cannot realize a capital loss in the event of a wash sale, which occurs when an investor sells an investment to realize a loss and buys it back within thirty days.
- For taxable accounts, the treatment of dividends depends on whether they are qualified or nonqualified. Most US company dividends are qualified and are taxed at the same rate as long-term capital gains. Depending on your income, these rates can be as high as 20 percent. Dividends from foreign companies and REITs (real estate investment trusts) are nonqualified. Investment income from nonqualified sources is taxed at the ordinary income rate, which can be as high as 37 percent.
If you do not rely on income from your investments to help you live day-to-day, you should focus on investments that appreciate, rather than those that generate interest and dividends. For investments that earn interest and dividends, also called current income, you will pay taxes each year. With appreciated securities, you decide when you want to sell and pay capital gains.
