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.