Never does a year go by without a more complicated tax code. The complete tax code now stands at more than 76,000 pages and millions of words.
Investors have to deal with quite a few different tax rules, laws, and policies. Let’s look at how different investments are taxed from the ground up.
- 401Ks and IRAs – While not technically an investment, traditional 401K and IRAs are taxed very simply. When you withdraw funds at retirement, the distributions are taxed at your income tax rate. The distributions from ROTH 401Ks and IRAs are not taxed at all since they are funded with post-tax dollars.
- Capital gains – Capital gains of any kind from stock or bonds is taxed at your income tax rate, or the long term capital gains tax rate if held for more than one year. The current long term capital gains tax rate can rise as high as 23.8% for singles who make more than $400,000 per year and couples who make more than $450,000 per year. Of course, capital gains are taxed at 0% if you are in the 15% tax bracket.
- Taxable bonds, CDs, and money markets – Interest earned from taxable fixed-income investments is taxed at your normal income tax rate. Be sure to note the difference between interest income from bonds, and capital gains from bonds. Interest income is taxed as ordinary income. Appreciation in a bond’s value – a capital gain – is taxed as a normal capital gain.
- Rental property – Income from rentals is taxed at ordinary income tax rates. Any and all capital gains, however, are taxed at your capital gains tax rate. Luckily, tax law is very favorable to real estate investors. A 1031 exchange allows you to sell an investment property to buy a similar property within 180 days. Any gains on the sale that are reinvested within the 180 day window are not taxed and the taxes are deferred.
- Qualified dividends – Depending on your income, dividends from stock holdings are taxed at the long-term capital gains tax rate of 0-20%, depending on your tax bracket. This tax rate obviously doesn’t apply if dividends are received in a tax-deferred account like an IRA or 401K.
- Non-qualified dividends – Dividends received from pass-through structures like real estate investment trusts, business development companies, closed-end funds, and master limited partnerships are usually non-qualified dividends and thus taxed at your ordinary income tax rate. The reason for higher taxation is simple: no corporate taxes were paid on the income before it was distributed to you so Uncle Sam requires you to pay based on your income tax rates.
Being smart about taxes is more than just knowing how to take a profit. There are special rules to follow with losses, too.
Capital Losses and Negative Income
Tax policy for good performing investments is fairly simple; income is taxed either at a capital gains tax rate, or your income tax rate. Income and capital gains are essentially the same with the exception of the amount paid to taxes for each dollar in gains or income.
Losses, however, work differently:
- Income – You can record any amount of lost income from an investment. If you own a rental property and lose $10,000 thanks to a vacancy and repairs, the loss is completely deducted against other earned income.
- Capital gains – Capital gains can be matched with unlimited capital losses, effectively wiping out one another. However, you can offset no more than $3,000 of other non-capital gains income with capital losses in the same year. Example: You have capital gains of $25,000 and capital losses of $30,000 on two different stocks. The two gains and losses offset up to $25,000. Of the remaining $5,000, $3,000 can be used to reduce earned income while $2,000 is carried over into the next tax year.
Knowing when to harvest tax losses is just as important as knowing when to take a profit. For those with taxable investments and a high earned income, taking investment losses each calendar year of $3,000 when possible allows you to save hundreds of dollars in taxes – enough money to more than pay for an accountant to properly file your returns.
Before investing in anything, always be sure how any gains or losses will be taxed, and compute an after-tax return. Comparing two investments on their pre-tax earnings is the very definition of comparing apples and oranges.