If you’ve been earning money or investing for any length of time, you know that Uncle Sam wants his cut. But figuring out your tax implications for various types of investments can be mind-boggling.
The investment choices you make (stocks, bonds, ETFs, mutual funds, real estate, crypto, etc.) all have different tax structures. On top of that, the account where you hold your assets such as a traditional IRA, Roth IRA, 401(k), or brokerage also factors into your tax liability.
To help you figure out how much liability you are responsible for, we’ve simplified the tax implications of various types of investments. With this guide, you can start to understand how taxes will hit your overall portfolio.
Although it seems complicated, tax liability really boils down to these questions:
- Will you owe on your investments?
- When do you owe taxes on your investments?
- How is the tax on the investment structured? (Do you pay capital gains tax or ordinary income tax?)
A Brokerage Account
A brokerage account is an investment account that has no special tax rules. If you only invest in retirement accounts, you may not have a brokerage account right now. However, if you’re investing for goals outside of retirement, it may make sense to open an online account at a low-cost brokerage.
Assets in a brokerage account: Typically brokerage accounts hold cash, bonds, stocks, ETFs, Mutual Funds, publicly traded Real Estate Investment Trusts (REITs), options, and other financial assets. Sometimes these accounts are able to hold cryptocurrency (crypto taxes addressed below).
What types of taxes will you pay on assets in your brokerage account? You’ll pay capital gains taxes when you sell (trade) assets in your brokerage account. You’ll pay capital gains taxes every year that you sell assets for a profit. If you’ve traded in the past year, you can expect to receive a 1099-B tax form from your brokerage.
Most assets inside a brokerage also produce dividend income. If you earn income from your investments, your brokerage will also provide a 1099-DIV at tax time. Dividends and other types of investment income are taxed as ordinary income which is typically a higher rate than the capital gains taxes.
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Are there penalties for withdrawing money? No. You will pay capital gains taxes on assets and ordinary income tax on dividends. You won’t pay penalties if you withdraw money from your brokerage account.
When will you expect to pay the taxes? When you have assets in a brokerage, you should expect to pay some amount of taxes every year. If you sell assets frequently, you may pay more in capital gains taxes. But don’t make the classic investing mistake of holding on to avoid taxes. If you’ve got a stock that doesn’t fit in your portfolio, start selling it even if you incur some taxes. After all, you’ll only pay taxes if you’ve made a profit.
A Traditional IRA
A traditional Individual Retirement Account (IRA) is an account that allows people to invest for their retirement. If you put money into a traditional IRA, you may get to take a tax deduction in the amount you invest. Your ability to take a deduction depends on your income. In 2022, you can contribute a maximum of $6,000.
For example, if you invest $6,000 this year, you can take a $6,000 tax deduction. However, you must pay ordinary income tax rates when you withdraw money during retirement. When you hit age 70.5, you have to take distributions (called Required Minimum Distributions).
Assets in a Traditional IRA: Most people hold cash, bonds, stocks, ETFs, and Mutual Funds in their Traditional IRA. Sometimes these accounts hold alternative investments like real estate, cryptocurrency, or other assets.
What types of taxes will you pay on assets in your traditional IRA? You may qualify to take a tax deduction when you contribute to a traditional IRA, up to the annual limit (currently $6,000). Each year, you’ll receive an IRS Form 5498 that shows your contributions. Great tax software will help you calculate whether you’re eligible to take the deduction.
When it comes to paying taxes, you will pay ordinary income tax on the amount you withdraw. The brokerage housing your account will provide a 1099-R when you make withdrawals. You have to start taking withdrawals by age 70.5.
Are there penalties for withdrawing money? You’ll pay a 10% penalty if you withdraw money before age 59.5.
When will you expect to pay the taxes? Investments inside a traditional IRA grow tax-free, even if you buy and sell assets. You’ll pay ordinary income on all money you withdraw from the account. The amount you withdraw is added to your ordinary income for the year.
A 401(k)
A 401(k) is a workplace retirement savings plan. For the most part, a 401(k) has the same tax rules as a traditional IRA. You get a tax break today, and your investments grow tax-free until you withdraw the money. At that point, you’ll pay ordinary income tax. You have to start taking 401(k) distributions at age 70.5.
Some workplaces offer a Roth 401(k). Those plans follow the same rules as the Roth IRA (listed below)
Assets in a 401(k): Most companies offer ETFs or Mutual Funds inside their workplace 401(k). A few people with self-directed 401(k) plans may be able to invest in single stocks, real estate, or other alternative assets through the plan.
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What types of taxes will you pay on assets in your 401(k)? Contributions to your 401(k) show up on your W-2. As an employee, you can deduct all the money you contributed to the plan.
If you’re self-employed, you can deduct your employee and employer contributions to the plan, but you’ll need to track this on your own.
When it comes to paying taxes, you will pay ordinary income tax on the amount you withdraw. The brokerage housing your account will provide a 1099-R when you make withdrawals. You have to start taking withdrawals by age 70.5.
Are there special rules for individual 401(k)s? If you’re self-employed and you have more than $250,000 in your account, you need to file a Form 5500-EZ every year. This form gives the IRS visibility to your account.
Are there penalties for withdrawing money? In general, you’ll pay a 10% penalty if you withdraw money before age 59.5. If you’re between 55 and 59.5, you can avoid the early withdrawal penalty if you withdraw money from your current 401(k).
You may also avoid penalties, if you set up a “self-funded pension” called substantially equal periodic payments.
When will you expect to pay the taxes? You will only pay taxes when you withdraw money from your 401(k).
Roth IRA
A Roth IRA is the inverse of a traditional IRA. You pay taxes on your contributions, but the account grows tax-free. When you withdraw money during retirement, the withdrawals are tax-free. Annual Roth contributions are subject to income and contribution limits.
As a bonus, you can withdraw your contributions without penalty at any time.
Assets in a Roth IRA: Most people hold cash, bonds, stocks, ETFs, and Mutual Funds in their Roth IRA. You might hold alternative investments like crypto, precious metals, or real estate in your Roth account.
What types of taxes will you pay on assets in your Roth IRA? If you contribute to a Roth IRA, you won’t qualify for an immediate tax deduction. But the account grows tax-free, and withdrawals are tax-free after age 59.5
Are there penalties for withdrawing money? You’ll pay a 10% penalty if you withdraw money before age 59.5.
When will you expect to pay the taxes? You’ll receive a Form 1099-R when you take money out of a Roth-IRA, but the withdrawals typically won’t be taxed.
Crypto Investments
Most people who own crypto, like Bitcoin, own it inside of a brokerage account, but crypto investing feels a bit different than other types of investing. For example, you may be surprised that crypto-to-crypto trades are taxable events.
The IRS treats crypto investing like stock investing. You’ll pay taxes when you trade crypto assets, or when you earn income through lending or staking. This detailed guide gives further details on crypto taxes, but the highlights are below.
Assets in a crypto account: Whether you hold your crypto in a hardware or software wallet, most people buy and sell crypto through a crypto exchange like Coinbase. You probably own stablecoins (pegged to the U.S. Dollar or other currency) and crypto.
What types of taxes will you pay on crypto? If you trade crypto, you’ll pay capital gains taxes whenever you make a profit. Most people need to use a tax calculator to figure out their tax liability from trading crypto. A crypto tax calculator will generate IRS Form 8949 for users. You can upload this form to TurboTax or TaxAct to figure out your tax liability.
If you earned income from crypto through staking, for example, you may receive a 1099-MISC from your brokerage. Otherwise, you need a report from a crypto tax calculator to show how much you earned.
Are there penalties for withdrawing money? No. There are no penalties for withdrawing crypto.
When will you expect to pay the taxes? Expect to pay taxes each year that you trade or earn money through crypto staking.
Real Estate
Whether you’re a house hacker renting out a room, a multi-family investor, or someone slinging rooms on Airbnb, you need to understand the tax implications of rental real estate. As an investor, you may have hired someone to keep the books for your rental portfolio, but most likely, you keep track of profit and loss by yourself. Because there are no “official forms,” you need to stay on top of the tax liabilities on your own.
If you’re participating in crowdfunded real estate, the tax implications are a bit easier. The company managing your investment will send you the necessary forms at tax time.
Types of rental real estate assets: Real estate investments range from short-term rentals (Airbnb), multi-family investments, and house hacking in your primary residence.
Crowdfunded real estate investments may include real estate syndications and privately held REITs.
What types of taxes will you pay on rental real estate? You’ll pay ordinary income on rental income you earn. Of course, you can deduct legitimate rental-related expenses when calculating their income for the year. All rental income is reported on Schedule E on your taxes. If you’re not sure how to properly report rental income and expenses, we recommend an easy-to-use tax filing software like TurboTax that will do the heavy lifting for you.
If you invest through crowdfunding sites, you’ll learn about your rental income through IRS form K-1. This gets copied to the Schedule E. Form K-1 also reports information about capital gains and losses from the business.
In some cases, you may receive a 1099-DIV or 1099-INT. Income on these forms is taxed as ordinary income (and it appears on Schedule D).
If you sell an investment property or your primary house, you have to pay taxes on the gains you make. Up to $250,000 of capital gains are shielded when you sell your primary house.
Are there penalties for withdrawing money? No. You can choose to spend your rental income or re-invest it.
Are there special tax advantages of house-hacking? If you rent out part of your house, you may qualify to deduct a portion of your property taxes, insurance, and utilities in your schedule E.
If you sell your primary residence, the first $250,000 of capital gains are not subject to taxation ($500,000 for a married couple). This is one of the only ways to earn tax-free money.
When will you expect to pay the taxes? You will pay taxes on their rental income or losses each year. You’ll only incur capital gains when you sell a property. If you’re managing your real estate finances, keep clean records so you can easily calculate your taxes each year.
Peer-to-Peer Lending
Online Peer-to-Peer (P2P) lending platforms, like Lenme, Lending Club, and Prosper, have made it relatively easy to earn money by lending it to other people. If you’re investing in this space, you’ll receive several investment forms that are otherwise fairly uncommon.
What types of taxes will you pay on P2P Lending? Interest from P2P lending is taxed at ordinary income tax rates. You’ll receive a form called 1099-OID from your online lending platform. This form indicates that the income you earned will be on Schedule B with other interest and dividend income.
If a loan fails, the losses will be reported on Form 1099-B. Capital losses count as a deduction against your income.
Are there penalties for withdrawing money? No. You can choose to spend your P2P loan money or reinvest it.
When will you expect to pay the taxes? You’ll pay taxes on P2P loan interest each year.
