What You Need To Know About Taxes and Investing


Taxes play an important role in your financial life. Their reach extends far beyond the dreaded April 15 (now July 15th for 2020) date and come into play much more than once per year. Taxes are actually involved in nearly every financial decision you make, chief among them being investing

Taxes are to investing as textbooks are to education—you can’t have one without the other. So how do taxes work when you are investing and in what ways can they impact and inform your investment strategy?

Let’s find out!

What Accounts are Taxable?

Before we dive into the type of taxes to look out for, let’s review what type of accounts generate taxes. 

Investment Accounts and Taxes

A taxable investment account, otherwise known as a brokerage account, is an account that is funded by after-tax dollars and allows the account owner to invest in nearly any type of security. Those securities could be

  • Stocks
  • Bonds
  • Mutual Funds
  • Real estate
  • ETFs

With taxable investment accounts, you will be required to pay taxes on any gain in the year that gain happened. So if you had a capital gain of $5,000 in 2020, that money will need to be claimed on your 2020 tax return. 

But what happens if your investments lose money? If you sell an asset at a loss (less than what you paid for it) that is known as a capital loss and doesn’t require any taxes. You can work to balance your tax bill by strategically balancing your capital gains and capital losses in a year as these losses can be used to reduce your taxable gains. In addition, you can deduct up to $3,000 in capital losses each year on your tax return with an option to carry forward the remainder. 

Retirement Accounts

Your long savings journey to retirement won’t come without its fair share of tax responsibilities. There are a couple of accounts that are tax-deferred accounts, which means the accounts contribute and accrue gains tax-free until distribution in retirement. The top two tax-deferred accounts are 401(k) and a Traditional IRA. 

Both of these accounts are funded with pre-tax dollars. All of the gains continue to grow tax-free and are only subject to tax when you take distributions in retirement as ordinary income. 

A Roth IRA and Roth 401(k), on the other hand, requires you to pay taxes when you contribute the money but not when you take it out, making it a vital savings vehicle for retirement. Roth IRAs do have income thresholds so if you make over $139,000 for single filers or $206,000 for married filers your options are limited, but you may be able to still contribute to a Roth by initiating a Roth transfer or backdoor Roth IRA in which you transfer funds from a traditional IRA into a Roth. 

What Taxes Will You Owe (And Why)?

If you are earning money on an investment, the IRS will want a portion of that gain. Below are three main types of tax you might deal with when investing. 

Capital Gains Tax

Capital gains tax is triggered when you make money, or realize a gain, on an investment. This comes from the sale of an investment at a higher price than what you paid. Sounds simple right? Well, the IRS has come up with a couple of stipulations to determine the percentage of capital gains tax that you will owe.

  • Household income
  • Length of time you held the investment

These two factors work to determine the percentage of tax you will pay on a capital gain. The first factor is based on your household income and your ordinary tax bracket and this number really informs the second criteria of how long you held the investment. 

If you retain an asset for less than a year, that is considered a short-term capital gain and will be taxed at a higher rate, anywhere 10%-39.6% depending on your tax bracket. But, by holding onto your investments for a year or more, you will be eligible for the more favorable long-term capital gains rate, which ranges from 0%-20%, though most people pay about 15%. Again, that percentage will depend on your tax bracket. 

Since selling assets costs you money, why is it worth doing? There are many reasons for people to sell assets including

  • Withdrawing money
  • Rebalancing a portfolio
  • Desire to make a change to investment strategy 
  • Changing risk tolerance 
  • Diversification needs
  • Market performance

The bottom line here is that your investments aren’t stagnant. They are moving and changing as your needs change. It is important to keep up with your investment strategy and understand what your needs and goals from it are to better create a plan that works for you. 

Ordinary Income Tax

The second type of tax that you will need to factor into your investments is the ordinary income tax. This tax comes into play when you earn income through your portfolio in the case of dividends and interest payments.

Dividends are an interesting category and another way for you to experience tax on your investments. Some investments pay quarterly or annual dividends to their individual investors which are basically just a check that goes into your account. Interest works in a similar way. As a shareholder, some investments will pay you regularly, resulting in income. 

This income is taxed at your ordinary-income rate. There are, of course, exceptions to this rule. Interest from municipal bonds is exempt from federal tax and for those lucky to live in California, they are exempt from state tax as well. If a dividend meets certain IRS regulations, it can be a qualified dividend that is taxed at the capital gains rate. 

How to Keep Taxes in Mind When Investing

Tax planning is an important step to get the most out of your investments. As you can see, they play a major role in your overall profits. When factoring in taxes into your investment plan there are a couple of strategies to keep in mind. 

  • Asset allocation
  • Asset location

Asset allocation is a strategy that looks at the specific securities that you invest in, like stocks and bonds, as well as the balance between those securities. Based on your aggressive risk tolerance, one account might be allocated to have 80% stock and 20% bonds, as an example. 

If asset allocation is the balancing of securities, asset location takes it a step further by determining the best place to house those securities in order to make them as tax-efficient as possible. Believe it or not, where your securities live makes a huge difference in your overall return. Creating a strong plan around the role taxes play in your investments can help you come up with a strong, balanced, comprehensive investment plan. 

Your investment goals will change and evolve as you do, so don’t be afraid to make changes when you need to. A situation might happen when you want to rebalance your portfolio or the market fluctuations support a different allocation depending on your risk tolerance and investment horizon. 

The most important thing is to remember the investment goals that you set and employ a level of flexibility so that your strategy stays in line with where you are at in your life now. 

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Mary Beth Storjohann, CFP® is an author, speaker, and financial coach who takes a fun, no-nonsense approach in working with individuals and couples across the country, helping them make smart choices with their money.

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