Just like your income, your investments are taxed. That means if you earned interest or dividends in the last year, or sold an investment for a profit, you'll probably owe tax on that money.
But not all investment accounts are taxed the same way. Here's what you need to know, according to two certified public accountants.
When it comes to investment accounts and taxes, there are generally three categories, says Matt Rosenberg, a certified public accountant and a member of the American Institute of CPAs' Financial Literacy Commission:
1. Tax-exempt accounts. This category includes Roth IRAs and Roth 401(k)s. You'll make contributions with after-tax dollars, but then, "investments held in these types of accounts can grow tax-free and are withdrawn tax-free," Rosenberg says.
2. Tax-deferred accounts. These include traditional IRAs and 401(k) plans, among others. You'll make these contributions with pretax dollars, meaning you'll get a tax break in the year you contribute, Rosenberg explains. "The investments in these accounts also grow tax-deferred and are not taxed until distribution," he says.
3. Taxable accounts: Rosenberg describes this as the least tax-friendly account category, composed of individual investment accounts you'd open through a brokerage. You use after-tax dollars to buy investments, and you'll pay taxes annually based on factors like your portfolio's income, and any profit or loss you take if you choose to sell some of your investments.
With a 529, for example, there's no tax break on contributions at the federal level, although many states offer deductions or credits. The money grows tax-free and can be withdrawn tax-free for qualified educational expenses.
HSAs have a triple tax advantage: Contributions are either pretax or deductible, grow tax-free, and can be withdrawn tax-free for qualified medical expenses.
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When it comes to tax-prep time, most of the attention is on those taxable brokerage accounts. "Paying attention to how the investments in these accounts are taxed is very important," Rosenberg cautions.
Different investments produce different kinds of taxable income throughout the year. You might receive:
- Interest payments. Some investments and financial products pay interest, including money market accounts, bonds, savings accounts, and CDs. Interest is the cost of using someone else's money, and in the case of these assets you're the one lending your money for a period of time.
- Dividends. If you own individual stocks, mutual funds, or ETFs, you may receive dividends, which are periodic payouts that some companies and funds share with investors. So-called "ordinary dividends" are taxed the same as regular federal income or wages, at your normal income tax rate. But "qualified dividends," which meet certain requirements, are taxed at the capital gains rate, which may be 0%, 15%, or 20%, depending on your tax bracket.
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If you're selling investments in a taxable investment account, you'll also need to be aware of how those profits or losses are treated at tax time.
To figure that out, it helps to understand the term capital gains, says Mark Prendergast, a certified public accountant and a certified financial planner at Inspired Financial in Huntington Beach, California. "Capital gains happen when you sell an asset for more than you paid for it," he says.
Say you bought $1,000 worth of mutual fund shares and later sold them for $2,200. You'd have a $1,200 capital gain and be taxed on that amount, Prendergast explains.
The amount you'll be taxed on capital gains depends on how long you have held an investment, Rosenberg says:
- If you hold a taxable investment for less than a year, you'll pay short-term capital gains rates, which is the same as your normal income tax rate.
- If you hold a taxable investment for one year or more, you'll pay the more favorable long-term capital gains rate as you would with qualified dividend income. That rate could be 0%, 15%, or 20%, depending on your tax bracket.
While it may be discouraging to lose money on an investment, selling at a loss can actually help you pay less in taxes. Investors can use capital losses to offset capital gains at tax time. Essentially, if you had $500 in gains and $500 in losses, those would cancel each other out and eliminate that tax bill. And if you have more losses than gains, you can claim up to $3,000 worth of those additional losses as a deduction against your regular wages.
While April 15 may seem far away, now is the time of year when brokerage firms start sending out documents detailing your investment income and capital gains for 2019. Understanding what you're looking for can help you get ready to file.
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