Investing in stocks, bonds, mutual funds, exchange-traded funds and other investment vehicles is a sound part of a personal finance strategy. A well-designed investment strategy can lead to income growth and financial success. But when you make money with investments, Uncle Sam comes knocking. Here's what you need to know about how investing money affects your taxes.
The Importance of Investing
Investing is vital for achieving long-term financial growth. Unlike traditional savings, investing allows your money to grow faster when market conditions and investment choices align. This growth is especially significant when considering long-term goals like saving for retirement or college, where the compounded investment returns can make a substantial difference.
However, investing isn't without risks. Balancing risk with potential rewards is vital to a successful investment strategy. Diversification is crucial, as it spreads risk across various assets, mitigating the impact of any one investment's poor performance. A well-balanced portfolio tailored to your risk tolerance and time horizon can provide the right mix of stability and growth potential, enabling you to reach your financial goals while keeping risk manageable.
How Taxes May Impact Your Investments
Taxes can significantly affect your investment returns, impacting the outcomes of your investments. Planning for taxes can help maximize your returns and minimize the tax burden. Here's how taxes impact the two most common types of investment gains.
- • Capital gains taxes: Capital gains taxes are due based on the profit from selling an investment. If you buy a stock and sell for a gain, for example, the amount you make from the stock is typically taxable income. In most cases, short-term capital gains require a higher tax rate than long-term capital gains.
- • Taxes on dividends: Dividends are cash payments made to shareholders. Some stocks pay dividends regularly, giving shareholders an income. Dividend income is taxed at a different rate than capital gains.
Understanding Different Types of Investments
Investments come in many forms. Here's a look at some of the most popular types of investments.
- • Stocks and bonds: Stocks represent ownership in a company and offer the potential for growth through price appreciation and dividends. On the other hand, bonds are fixed-income investments where you lend money to an issuer (like a government or corporation) in exchange for regular interest payments and the return of the bond's face value at maturity. Here's a primer on the differences between stocks and bonds.
- • Mutual funds and ETFs: Mutual funds and exchange-traded funds (ETFs) pool money from many investors to purchase a diversified portfolio of stocks, bonds or other securities. They are managed by professional fund managers, offering investors an easy way to diversify their investments.
You may also invest in alternative asset classes, such as real estate, cryptocurrency commodities, hedge funds, private equity or artworks. Each has its own risk and reward potential. Wise investors only invest in what they understand.
How Investing Changes Your Taxes
A taxable event for investors refers to any financial action or transaction that results in a tax liability to the government. This includes events such as selling stocks at a profit, receiving dividends or earning interest, each triggering a requirement to report this income and potentially pay taxes.
Taxable investment accounts
Earning a capital gain after holding an investment for a year or less is considered a short-term capital gain. In that case, it's taxed at your regular income tax rate. Long-term capital gains are taxed up to 15% for most individuals, depending on your annual household income.1
Dividend income can be a little more complicated, as companies can pay dividends differently. In most situations, ordinary dividends are taxed at your regular personal income tax rate.2
Retirement accounts: IRA and 401(k)
Pre-tax investment accounts, such as traditional IRAs, 401(k)s, 403(b)s, 457 plans and certain self-employed IRAs, allow investors to contribute funds before income taxes are applied. This means that contributions reduce your taxable income, potentially lowering your tax bill in the year you contribute. The funds in these accounts grow tax-deferred, meaning you only pay taxes on the gains, dividends or interest once you withdraw the funds, typically in retirement.
After-tax investment accounts, like Roth IRAs, operate on a different principle. Contributions to a Roth IRA are made with after-tax dollars, meaning there's no immediate tax deduction. However, the benefit comes in the form of tax-free growth and tax-free withdrawals in retirement.
Both pre-tax and after-tax accounts offer excellent tax benefits when used appropriately. When in doubt, consult with a trusted tax professional.
Tax Strategies for Investors
While taxes are required for most people with investment profits, you can legally follow several methods to lower your tax bill. Here are several popular strategies for investors to save on taxes.
Tax-loss harvesting
With tax loss harvesting, investors can capture tax losses by buying and selling strategically as investment values naturally rise and fall. If you sell an investment at a loss and rebuy it immediately, you can use that loss to offset investment gains, saving you from paying taxes on all capital gains.1
Timing of investments
Timing the markets to make money from investing is risky for most investors, but deciding when to invest can help you better control your tax obligations. For example, if you're considering selling an investment in less than one year, holding it until you pass the one-year mark can turn a short-term capital gain into a long-term capital gain, typically taxed at a lower rate. Similarly, selling before or after New Year's can put the gains or losses into a different tax year, where you may have a more or less favorable tax situation.
Retirement accounts and taxes
As briefly discussed above, retirement accounts can offer unique tax benefits not available from traditional taxable brokerage accounts. Pre-tax investments lower your taxable income in the year of your contribution, and withdrawals in the future are taxable, likely at a lower tax rate. With after-tax accounts, contributions are taxed, but qualified withdrawals in the future are tax-free. A health savings account is a unique account where contributions and eligible withdrawals are tax-free.3
The Bottom Line: Never Forget About Taxes When Investing
Investing is key for long-term wealth growth, helping your money outpace inflation and meet goals like retirement. Yet it's crucial to grasp how taxes affect these investments, as they can significantly impact your returns. Understanding tax treatments and using tax-advantaged accounts are essential for smart investing.
While many households can manage their taxes, others are not as confident that they're making the best financial decisions. A licensed financial advisor or tax professional may be able to help you find ways to improve your tax situation and optimize your investments for taxes.
Eric Rosenberg is a financial writer, speaker and consultant based in Ventura, California. He is an expert in banking, credit cards, investing, cryptocurrency, insurance, real estate, business finance and financial fraud and security. His work has appeared in many online publications, including Time, USA Today, Forbes, Business Insider, NerdWallet, Investopedia and U.S. News & World Report. Connect with him and learn more at EricRosenberg.com.
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