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Be Wise to Investment Taxes

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:

For your brokerage accounts, there are essentially three types:

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):

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.