When it comes to investments, there are a lot of things to consider. One of the most important is how your investment will be taxed. This can seem complicated at first, but it’s actually pretty straightforward. In this blog post, we’ll break down how investments are taxed and give you a practical example to help illustrate the point. By understanding how taxes work, you can make more informed investment decisions and potentially save money in the long run.
Stock in a company
Company stocks are taxed differently than other investments, such as bonds or mutual funds. When you sell stock, you may owe capital gains taxes. These taxes are based on the difference between what you paid for the stock (your cost basis) and the price you sold it for. If you held the stock for less than a year, you’ll pay short-term capital gains taxes. These are taxed at your marginal tax rate, which is the rate you pay on your last dollar of income. If you held the stock for more than a year, you’ll pay long-term capital gains taxes. These are typically lower than short-term capital gains taxes and are taxed at a maximum of 15%.
Stock options
If you have stock options, you may also owe taxes when you exercise those options. When you exercise an option, you’re essentially buying the stock at the strike price. If the current market price is higher than the strike price, you’ll have a capital gain. This gain will be taxed at your marginal tax rate if you hold the stock for less than a year. If you hold the stock for more than a year, it will be taxed at the long-term capital gains rate.
Bonds including municipal bonds
Bonds are loans that you make to a company or government. In exchange for loaning your money, they agree to pay you interest over time and return your principal (the amount you loaned) when the bond matures. Municipal bonds are a type of bond issued by state and local governments. Interest from municipal bonds is typically exempt from federal income taxes, and may also be exempt from state and local taxes if the bonds are issued in your state of residence.
Mutual funds
Mutual funds are a type of investment that pools money from many investors to purchase a portfolio of stocks, bonds, or other securities. When you invest in a mutual fund, you own shares of the fund. The value of your shares will go up or down as the fund’s investments do.
Gains from mutual funds are typically taxed at your marginal tax rate, and losses can be used to offset other capital gains (up to $3,000 per year).
Exchange-traded funds (ETFs)
Exchange-traded funds (ETFs) are a type of investment that is similar to a mutual fund. ETFs are traded on stock exchanges and can be bought and sold throughout the day. Like mutual funds, ETFs pool money from many investors to purchase a portfolio of stocks, bonds, or other securities.
Restricted stock units (RSUs)
Restricted stock units (RSUs) are a type of compensation that companies may give to their employees. RSUs are similar to stock options in that they give you the right to purchase shares of the company’s stock at a later date. However, with RSUs, you don’t have to pay anything to exercise the option. Instead, the shares are typically given to you at the vesting date. If you hold the RSUs for more than a year, they will be taxed at the long-term capital gains rate. If you hold them for less than a year, they will be taxed at your marginal tax rate.
Real estate investment trusts (REITs)
Real estate investment trusts (REITs) are a type of investment that specializes in owning and operating income-producing real estate. REITs can own a variety of property types, such as office buildings, shopping centers, apartments, warehouses, and hotels.
When you invest in a REIT, you’re essentially buying shares of the trust. The trust then uses the money to buy and operate income-producing real estate. REITs are required to distribute at least 90% of their taxable income to shareholders in the form of dividends. These dividends are typically taxed at your marginal tax rate.
Rental real estate
If you own rental real estate, you’ll owe taxes on the income you earn from rent. Rental income is typically taxed at your marginal tax rate.
You may also be able to deduct expenses related to your rental property, such as repairs, mortgage interest, and property taxes. These deductions can offset some or all of the income you earn from rent, reducing the amount of tax you owe.
Selling a business
If you sell a business, you may owe taxes on the proceeds. The amount of tax you owe will depend on how much profit you made from the sale and what type of business it was. For example, if you sold a sole proprietorship, you’ll pay taxes on the profit at your marginal tax rate. If you sold an S corporation, you’ll pay taxes on the profit at the capital gains rate.
Cryptocurrency
Cryptocurrency is a type of digital asset that uses cryptography to secure its transactions and to control the creation of new units. Cryptocurrency is decentralized, meaning it is not subject to government or financial institution control. Bitcoin, Ethereum, and Litecoin are all examples of cryptocurrency.
When you buy or sell cryptocurrency, you may owe taxes on the gain or loss. The amount of tax you owe will depend on how long you held the cryptocurrency and what your marginal tax rate is.
Investments within a retirement account
If you have an investment within a retirement account, such as a 401(k) or IRA, you will not owe taxes on the gains from that investment until you withdraw the money from the account. When you do withdraw the money, it will be taxed at your marginal tax rate.
Tax on Dividends
Dividends are distributions of a company’s profits to its shareholders. Dividends are typically paid out quarterly. When you receive dividends, you may owe taxes on the income. The amount of tax you owe will depend on your marginal tax rate.
Qualified dividends, which are dividends paid by U.S. companies or certain foreign companies, are taxed at the long-term capital gains rate. Non-qualified dividends, which are dividends paid by other types of companies, are taxed at your marginal tax rate.
You may also owe taxes on dividends if they are paid into a retirement account, such as a 401(k) or IRA. When you withdraw the money from the account, the dividends will be taxed at your marginal tax rate.
Tax on Interest
Interest is the money you earn from lending your money to someone else. When you receive interest, you may owe taxes on the income. The amount of tax you owe will depend on your marginal tax rate.
You may also owe taxes on interest if it is paid into a retirement account, such as a 401(k) or IRA. When you withdraw the money from the account, the interest will be taxed at your marginal tax rate.
Tax on Capital Gains
Capital gains are profits from the sale of an asset, such as a stock or bond. When you sell an asset for more than you paid for it, you have a capital gain. If you sell an asset for less than you paid for it, you have a capital loss.
Tax Losses and Wash Sales
If you have a capital loss, you may be able to use it to offset capital gains. For example, if you have a $1,000 capital gain and a $500 capital loss, your net capital gain would be $500. You would only owe taxes on the $500.
If you sell an asset for a loss and then buy it back within 30 days, the IRS considers this a wash sale. A wash sale occurs when you sell an asset for a loss and then buy it back within 30 days. If you have a wash sale, you cannot use the capital loss to offset capital gains.
Collectibles including rare stamps, coins, art, and more
If you sell a collectible for more than you paid for it, you may owe taxes on the gain. Collectibles are taxed at your marginal tax rate.
Examples of collectibles include:
-Stamps
-Coins
-Art
-Furniture
-Cars
Ways to offset capital gains taxes
If you’re wondering how to avoid capital gains tax, there are a few strategies you can use.
One way to avoid capital gains tax is to invest in a retirement account such as a 401(k) or IRA. Investments within these accounts are not taxed until they are withdrawn. This allows your investment to grow tax-free until you retire.
Another way to avoid capital gains tax is to invest in a tax-advantaged account such as a 529 plan. These accounts are designed to encourage saving for education expenses. Contributions to these accounts are typically not taxed, and withdrawals can be taken tax-free if they are used for qualifying education expenses.
Finally, you may be able to avoid capital gains tax by selling your investment for less than you paid for it. This is called a capital loss. Capital losses can be used to offset capital gains, reducing the amount of tax you owe.
Capital gains taxes are a complex topic, and there are many factors to consider before making any investment decisions. Be sure to consult with a tax advisor to determine how your investments will be taxed.
Tax Software Designed for Investors
Investors have unique tax needs, and traditional tax software can’t always meet those needs. For serious investors, we recommend using specialized tax software designed specifically for investors.
Investors Tax Solutions is a leading provider of tax software for investors. Their software integrates with popular investment tracking platforms such as Mint and TurboTax, making it easy to track your investments and calculate your taxes.
Another popular option for tax software is H&R Block’s Tax Software for Investors. This software is designed to help investors easily calculate their taxes, including capital gains taxes. Both these companies offer a free trial of their software, so you can try it before you buy it.
Final Thoughts
Investments are taxed in a variety of ways, depending on the type of investment and how it is held. It’s important to understand the tax implications of your investments before making any decisions. If you’re looking for a way to avoid capital gains taxes, consider investing in a retirement account or a tax-advantaged account such as a 529 plan. Be sure to consult with a tax advisor to ensure you are taking advantage of all the tax breaks available to you.
Disclaimer: MoneyMagpie is not a licensed financial advisor and therefore information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence.
