At a glance:
Summary of taxes on investments
The purpose of investing is to have your money make more money for you. However, your profits can be dampened greatly when tax time rolls around.
Unless your investment occurs in a tax-sheltered account, you will find yourself handing over a chunk of your earnings to the tax man. That is why tax planning is a large part of investing in today's markets.
How you’re taxed on investments
The effect of taxation on income and accumulated value is a key investment consideration. Some important terms:
After-tax and pre-tax investments
Is the income you put into an investment subject to taxation? If so, it is an after-tax investment. Typically, savings accounts and most trading in stocks and bonds involve after-tax income.
Pre-tax means that you do not pay taxes on the income you invest—either because the tax is never deducted (such as with contributions to a 401(k) plan) or because you can write your investment off as a tax deduction (like a portion of your contribution to an individual retirement account).
What are capital gains?
In order to encourage investment, capital gains (profits on securities sold) are taxed at a rate lower than that of regular income, provided you hold the investment for more than 12 months. These are referred to as long-term capital gains. If you hold a security for a year or less, your capital gains are taxed as regular income.
Some investments, such as mutual funds, that reinvest dividends may show appreciating values; however, those values are not all capital gains. Reinvested dividends add to the basis of an investment, which needs to be subtracted from the value to accurately calculate capital gains.
This means that the value that builds up in your investment is not subject to taxes until you take it out as income. Most retirement plans and annuities are tax-deferred. Tax-deferred investments usually entail increased taxation as a penalty if you withdraw your funds before a certain date.
Tax strategy for your investments
Whether they pay regular interest or whether you cash them in, investments add to your income, which can add to your tax burden. The taxation of investment gains can be an extremely complex subject, and the more complicated your portfolio, the more likely it is that you will need expert tax advice.
Here are a few basic things to be aware of.
Capital gains or not?
In order to encourage investment, the government taxes capital gains at a lower rate if you hold them for a certain period. But not all accrued value is capital gains.
For instance, even though you might buy a zero coupon bond at a discount and redeem it for much more money, some or all of the increased value may be taxed as ordinary interest income, not capital gains.
Some investments, especially funds set up for retirement, provide several ways to shelter your money from taxation. Tax-deferred investments allow funds to build up tax-free in your investment; you pay taxes on your earnings only when you take them out as cash.
Other plans permit pre-tax investment—that is, the amount of your income you invest is not subject to current taxation. Still others permit you to deduct a portion of your invested funds from your income for tax purposes.
Knowing the current state of the tax code regarding investment earnings is a full-time job. With some investments, you must pay tax on your earnings, even though you cannot use them as income. In some instances, a portion of your earnings will be taxed one way, another portion in a different way.
Unless you want to spend lots of time reading IRS publications, you should plan to get expert advice—advice you will have to pay for and factor into the cost of your investments.
How to avoid taxes on investments
Compound interest is interest paid on interest. At 5 percent interest compounded annually, you will have $105 after the first year. If you keep this investment for another year, you will be paid interest on your original $100 and on the $5 you made in interest the first year.
The longer you invest your money, the higher your interest payments will grow, not only on your original amount but on the additional interest you earn each year. This is what makes compounding interest so powerful.
The longer an investment is allowed to compound interest, the higher your returns will be.
Avoid the tax man
It will not do you a whole lot of good to compound the interest on your investments only to watch it get taken by the IRS. Fortunately, there are a few ways to compound your interest and avoid paying more tax than necessary.
Unless you invest in a tax-sheltered account, you will have to pay taxes on any investment growth at your regular income tax rate. Interest rates paid on bank accounts, bonds, and dividends (shared profits) are all generally taxable. If you are in a moderate tax bracket, this could mean around 30–35 percent in both state and federal taxes. So your 10 percent rate of return could end up being closer to 6 percent after taxes.
The answer can be found in tax-sheltered accounts. A tax-sheltered account lets interest grow within your account without being taxed until it is withdrawn. This puts the power of compounding back into your hands, because your investment will continue to grow faster without taxes cutting into your growing interest.
What kinds of tax-sheltered investments can you use to protect your compounded interest?
Tax-deferred retirement plans such as individual retirement accounts (IRAs)
Municipal bond funds with reinvested dividends
Millions of investors have chosen these investments to enable as much of their wealth as possible to keep growing.
Summary of taxes in investments
Investing is critical to your financial independence, yet taxes threaten to diminish your earnings. As a savvy investor, you need to be aware of the tax consequences of your investments.
By investing wisely to take advantage of the lowest possible tax consequences while keeping the maximum return on your investments, you can achieve financial independence. To do this, you need to be aware of the distinctions between ordinary income and capital gains, as well as tax-advantaged investing.
Remember, it's not how much you earn, it's how much you keep.
This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.
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