Investment Accounts and Taxes

Taxes are a fact of life, and investment accounts that are not an IRA or a Roth IRA can have an impact on your taxes. For non-retirement investment accounts, you will receive a 1099 at tax time that outlines the income that the account generated and categorizes that income since different types of investment income receive different tax treatment. While calculating the taxes on non – retirement accounts is definitely more complicated than figuring out the taxes from an IRA (you pay tax on IRA funds only when you take them out of the account), you’ll see that some types of investment income are actually treated better than your ordinary income, and that there are things you can do to mitigate investment taxes.

Dividends: Companies often pass a portion of their profits on to investors as dividends. Those dividends can be classified as ordinary dividends, which are taxed at the investor’s marginal tax rate, and qualified dividends, which are taxed at the investor’s tax rate or 15%, whichever is lower. For a dividend to be considered qualified, the stock must be held for a certain amount of time before and after the dividend is paid.

Interest: Federal and corporate bonds pay interest, which is taxed as income to the investor. Interest paid by municipal bonds, issued by states, cities, and school districts, are usually federal tax – free, and municipal bonds from the state where you pay taxes usually avoid state taxes as well. Note that certain municipal bonds can be subject to alternative minimum taxes, so if you are subject to AMT you need to review those bonds to see if they will be tax-free.

Capital Gains: When you sell an investment at a profit, you need to report the increase as a capital gain. If you owned the investment less than twelve months, the gain is considered short – term, and is taxed at your marginal tax rate, the same as ordinary income. If you owned the investment for more than twelve months, then the gain is treated as a long – term gain. Long – term gains get preferential tax treatment. There are some nuances involved, but for our purposes, they are generally taxed at no more than 15% except for very high income earners.

Capital Losses: While capital gains are taxed, capital losses can be a tax asset.  We never set out to lose money on an investment, but investment losses can be used to offset gains and reduce your tax bill. For figuring out gains and losses, first all short – term losses are subtracted from short – term gains, and all long – term losses are subtracted from long – term gains. Then a loss of one type can be used to offset a gain of another type. If the total results in an overall loss, up to $3000 of that loss can be used each year to reduce regular income, and losses in excess of $3000 can be carried over to future years and used to offset gains then or more income until all the loss has been used up.

Mutual Funds: When you invest in mutual funds, they pass through the interest and dividends generated by the underlying investments that they hold. If the mutual fund managers sell stocks or bonds during the year, they also have to pass on any net capital gains in the form of a distribution to shareholders at the end of the year.

All of this may sound a bit complicated, and we advise our clients who invest outside of retirement accounts to hire a tax preparer to help sort everything out correctly. But the complexity behind how investments are taxed can also create opportunities to mitigate those taxes. To see how we can help you use the different types of investment income and capital gain treatment to your advantage, here’s an article we put together a while ago on Tax Managed Investing.