If you have a taxable investment account vs a tax-favored retirement account you are subject to tax on capital gains, interest income, and dividends. Each of these are subject to different tax treatments that can be confusing.
Let’s start with capital gains, they are realized when you sell an investment for an amount that is higher than your cost basis (what you paid plus reinvested dividends and capital gains). If you have held the investment for less than 12 months, you have a short-term capital gain and will pay taxes at the same rate you pay on your earned income – up to 37%. If you have owned the investment for longer than 12 months, you will have long-term capital gains and will pay 0%, 15%, or 20%, depending on your income tax bracket. If you sell an investment for less than your basis you will have a loss and you can use that to offset capital gains for the year. If losses exceed gains, you can use up to $3,000 of losses to reduce your taxable income each year until your losses have been exhausted.
Next, interest income is generated from fixed income investments like bonds, money markets, and CDs. These investments generally pay income monthly, quarterly, or semi-annually. Interest income is treated like your earned income and taxed at your income tax rates.
Lastly, some stocks or stock mutual funds pay dividends to investors. These dividends are classified into two categories – qualified and non-qualified. Most dividends fall into the qualified category and are taxed like capital gains mentioned above – 0%, 15%, or 20%. Non-qualified dividends are taxed at ordinary income tax rates.
On top of these tax rates you may be subject to the 3.8% Obamacare surcharge. This applies to single taxpayers with an adjusted gross income (AGI) of over $200,000 and couples filing jointly with AGI over $250,000. The surtax only applies to net investment income over these thresholds. For example if a taxpayer filing single has an AGI of $240,000 with $10,000 of investment income or gains, they will pay the 3.8% surtax on the $10,000. With the surtax, many investors will be subject to a 23.8% capital gains rate.
As you can see taxes on investment gains can be complicated and expensive. If you have a portfolio that includes tax-favorable retirement accounts, proper planning can help you minimize the tax liabilities by placing more tax favorable investments into taxable accounts and those investments with higher tax consequences in the tax-favored accounts.
Contact WealthCharter to evaluate your tax situation today.