When it comes to tax implications of your investment portfolio, it’s tough to understand the big picture and how laws, codes, exemptions, deductions, and credits affect your entire financial life. Tax law is expansive and seems ever-changing.
And in fact, taxes often are literally changing as Congress passes or repeals pieces of the tax code every single year. There’s a reason that understanding and managing all aspects of your taxes can be more than a full-time job that falls between your financial advisor and your CPA.
Your overall tax burden depends on a lot of things. Yes, your income influences how much you owe in taxes. But it’s far from the only piece.
How you generate that income, including where you invest your money, matters too.
It’s good to have a basic understanding of the tax implications of your specific investment portfolio. What can look like a great place to invest on the surface may come with lots of tax complications that leave you owing far too much to Uncle Sam (everyone’s ‘favorite’ uncle).
Most investment vehicles come in a few main forms: taxable, tax-deferred, and tax-exempt. Let’s break down these categories first to start understanding the tax implications within your investments.
Taxable Investments and Accounts
The name ‘Taxable Accounts’ pretty much speaks for itself. Investors must pay taxes on their investment income in the year it was received.
Taxable accounts include things like individual or joint investment accounts, bank accounts, and money market mutual funds.
These kinds of investments are good to have in your portfolio because you have immediate access to them without penalty (making them ‘liquid’ assets). You can sell an asset and receive the funds immediately — but you’ll trigger taxes that you’ll need to pay.
Tax-Deferred Accounts Ease Your Tax Burden Today
Tax-deferred accounts grow tax-free until you withdraw money from them. Interest, dividends and capital gains are all ways that the accounts can grow tax-free over time. Tax-deferred accounts include IRAs, 401(k), Health Savings Accounts, and annuities.
Our taxes tend to be higher during our working years than our retirement years. Deferring taxes on investments when you’re in a high tax bracket now can help you save money because it strategically arranges your tax burden into a more favorable position for you in the future.
It could also help you contribute more upfront. Contributing to a tax-deferred account today can lower your adjusted gross income for the current tax year.
If it lowers it enough to push you into a lower tax bracket, you could pay less in taxes today and when you withdraw the money in retirement (where most of us will once again be in a lower bracket than during the height of our working and income-earning years).
Tax-exempt accounts are investment vehicles that allow you to contribute money to them, without paying taxes on contributions or earnings. These accounts are few and far between, and are usually for a specific purpose.
Municipal bonds (bonds issued by a city/state that are free from federal tax requirements) or a 529 college savings plan are both tax-exempt investments.
529 plans must be used on qualified education expenses to skip the taxes. Municipal bonds, on the other hand, allow you to earn interest income without being subject to state, local or federal taxes. That means any money you make from your bonds is pure profit (although municipal bonds yield income at much lower rates than taxable bonds and stocks because of their tax-exempt status).
The Tax Implications of Different Investments
Having a portfolio that properly balances your assets (with the right asset allocation) is critical to investment success. But just as important as the right mix of asset classes is the right mix of tax-advantaged accounts, whether they’re tax-deferred or provide some other benefit.
Keeping only your company 401(k) doesn’t make for a strong investment portfolio that allows you to balance your tax obligations today with what you will need to pay in the future.
A portfolio with a mix of accounts such as a 401(k), plus a Roth IRA and taxable brokerage accounts, along with use of appropriate tax-exempt savings vehicles like a 529 plan allows you to more evenly distribute your tax burden throughout your life — and it ensures that special savings, like money for college, aren’t subject to unnecessary taxes.
Understanding Different Tax Rates on Current Income and Capital Gains
Another tax implication to watch? The difference in the way current income and capital gains get taxed.
Your current, or ordinary, income includes things like how much you make from your job and any money you earn from interest on investments each year. Capital gains refers to the difference between the price that you paid for an asset in a taxable investment (like a share in a mutual fund, for example), and the price at which you sold it. If you sold that asset and made a profit, that’s a capital gain.
Capital gains and ordinary income aren’t taxed in the same way. Current income is usually taxed at the investor’s tax bracket rate. If you’re in the 25% tax bracket, your current income from investments (remember, that’s interest) gets taxed at the same rate.
What Tax Implications Does Your Portfolio Carry?
Capital gains taxes are broken into long-term gains and short-term gains. Long-term generally refers to being held for one year or more, while short-term is anything less than a year. Long-term capital gains are taxed at a lower rate than short-term gains to encourage people to invest long-term in companies.
Long-term capital gains are taxed at a flat rate. For 2017, it was a flat rate of between 15%-20% depending on your tax bracket. But short-term capital gains are taxed at regular income rates.
Again, it depends on which tax bracket you’re in — but long-term capital gains typically receive more tax breaks than short-term gains.
In addition to capital gains, your investments and the tax implications of your portfolio can be affected by capital losses. This is when you sell an asset and don’t make a profit, but rather lose money.
While most investors don’t make losing money one of their goals, there is one small consolation when it happens: you can use your capital losses to lower your tax bill, since they help offset the tax burden triggered by capital gains. This is known as tax loss harvesting.
Obviously, the tax ramifications of your investments and where you hold them are complex issues. You need to know that not all investment portfolios and strategies are created equal. Those that were planned with an eye on the tax implications of where each dollar was invested will likely provide you with a more valuable nest egg in the long run than those that did not take taxes into account.
About the Author
Charlie Shipman left Wall Street and founded Blue Keel Financial Planning in 2014 to provide independent, fee-only investment management and comprehensive financial planning to professionals, business owners, entrepreneurs and their families. His goal is to help clients align their finances with the lives they want for themselves and their families. Areas of expertise include: cash flow planning and budgeting, business planning, financial planning, portfolio management, estate planning and risk management. Charlie has been featured in many respected online financial publications such as MSN, Yahoo!, Nasdaq, Money, CBS News, The Motley Fool, and Investopedia. Charlie resides in Weston, CT with his wife and two young children, and serves as Treasurer for the Friends of Weston Public Library, Assistant Treasurer for Emmanuel Episcopal Church, and was a member of the Town of Weston Strategic Planning Committee.
For more information, or to reach Charlie, send an email to firstname.lastname@example.org.