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Be Wise to Investment Taxes

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When it comes to investing, there are two things you can control – how much you pay in fees and how much you pay in taxes. With fees, it’s pretty straightforward because fees are disclosed up front. A brokerage charges you $x per trade, a mutual fund company pulls x% in expenses, and both are required by law to make those very clear.

Taxes are slightly different. The tax code can be complicated and it doesn’t help that there are so many different “types” of investment accounts from 401(k)s to Roth IRAs to your plain vanilla brokerage account. When it comes to investing, what you buy and where can be just as important as what you buy.

When it comes to investments, there are four “types” of tax you need to be aware of:

  • Ordinary income: Ordinary income is taxed the same as the income you earn from your job. This includes interest from your bank accounts, from Treasury and corporate bonds, and from things like REITs and the like.
  • Short term capital gains: Short term capital gains is what you pay on profits from investments you hold for less than a year, these rates are the same as ordinary income.
  • Long term capital gains: Long term capital gains is what you pay on profits from investments you hold for more than e year, and these rates are much lower (0 – 15% depending on your tax bracket).
  • Qualified dividend income: A qualified dividend is one paid by a company to its shareholders, your only requirement is that you must hold the shares for at least 60 days before or after the payout. This is taxed at the long term capital gains rate.

For your brokerage accounts, there are essentially three types:

  • Taxable brokerage account: If you open an account with a brokerage, chances are it’ll be a taxable brokerage account. You don’t get any tax benefits for contributions/deposits and you pay taxes immediately on any realized profits.
  • Tax free account: A Roth IRA is an example of a tax free account, where you aren’t taxed on any of the profits.
  • Tax deferred account: A 401(k) is an example of a tax deferred account, where you aren’t taxed on the profits and you get the deduct contributions; taxes are due whenever you start taking payments in retirement.

Ideally, you want all of your long term and dividend income taxed investments to live in a taxable brokerage account, where you’ll benefit from the lower tax rates. Any short term or ordinary income taxed investments will want to live in a tax free or tax deferred account.

For example, let’s say you own a share of Bargaineering Enterprises and we give a $100 qualified dividend each year. Here’s how much tax you’d pay in each type of account (assuming 25% bracket):

  • Taxable brokerage account: $15 (assuming 15% LTCG rate)
  • Tax free account: $0
  • Tax deferred account: $25 (but deferred until retirement)

Why not buy it in a tax free account? Opportunity cost. Since you’re limited in how much you can contribute to your Roth IRA, it’s better to use that money on short term investments (where instead of saving just $15, you can save $25).

So, the next time you’re looking to buy something, think about the tax implications.

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9 Responses to “Be Wise to Investment Taxes”

  1. tbork84 says:

    So whats the ticker symbol for Bargaineering Enterprises?

  2. zapeta says:

    Another consideration might be the time frame that you have. If you need to access the investment capital or returns in 5 years, it doesn’t make sense to lock it up in one of the tax advantaged accounts where you can’t get it out. If you buy a share of Bargaineering Enterprises and want to pocket that dividend each year in cash, you don’t have much choice but to own it in a taxable account.

  3. Scott says:

    There’s also tax-free FUNDS like state/local bond mutual funds. Tax implications vary, but they can definitely be worth a look-see.

  4. mannymacho says:

    The government has been so fickle with tax treatment of different investments that it’s really difficult to know how your investments will ultimately be taxed and what the rates will be.

  5. Don C says:

    Don’t foget about investing in gold and other precious metals whch may be taxed at 28%!

    • skylog says:

      this is a good point that i do not think too many people are aware of. i may be wrong, but i do think there was (or is) legislation being discussed about this very topic.

  6. Strebkr says:

    Watching your investment taxes is a very close 2nd in terms of your investments ability to grow and create income in the future.

  7. skylog says:

    one factor to think about, not that there is much that one can do about it, is how the tax laws may change in the future.


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