So much investment advice centers around raw returns. Most rates of return you see on standard investments are before the IRS takes its share.
The impact of taxes on overall returns is often glossed over or ignored altogether.
However, ignoring tax considerations can lead to lower returns and lost opportunities. So, today’s blog post will discuss some of the more common (and commonly ignored) tax implications of investing.
Capital Gains Tax
This is a doozy for a couple of reasons. First, it’s the most common investment tax. Next, it always involves choosing the lesser of two evils.
Here’s what we mean.
Anytime you sell a capital asset like stocks, bonds, real estate, or mutual funds, the government takes its share. If you hold the asset for less than a year, the IRS takes significantly more. That’s called a short-term capital gain.
If you hold it over a year (a long-term capital gain), the IRS cut is more reasonable. But you will still likely take a tax hit.
So, when investing, you’ll want to try to hold on to assets for over a year. You’ll also want to talk to a tax advisor about investment vehicles that can help defer taxes until you are ready for them.
More on that in a bit. Now, let’s move on to the next common investment tax.
There’s a lot going on here; much more than can be covered in this post.
But for now, it’s enough to know that if you invest in stocks, mutual funds, exchange-traded funds (ETFs), or Real Estate Investment Trusts (REITS), then this is worth a read. That’s because many stocks, and all REITS, pay a dividend.
And, you guessed it, that money may be subject to taxes.
Some dividends are taxed at rates similar to long-term capital gains, but non-qualified dividends are taxed at your ordinary income rates.
How dividends are treated depends on the type, how long it was held, and your income tax bracket.
So, suffice it to say having a good tax advisor on your team will be helpful when navigating the dividend tax world.
Remember those investment vehicles mentioned earlier? They can’t get you out of paying taxes, but they can help determine when you pay them.
For example, investing through a 401(k) may be tax deductible, reducing your current tax bill. You may be able to defer taxes until you are retired and in a lower tax bracket. So, in the long run, you still pay taxes, just not as much.
And the good news is there are quite a few tax-advantaged accounts. They can be retirement accounts like an IRA, education savings accounts, and Health Saving Accounts.
The bad news is everyone’s financial situation is unique, and investing in the wrong thing to get a tax benefit may backfire.
So, having a tax advisor on your team before investing in these is always a good idea.
Having one on your team after the purchase is a good idea, too, especially when it comes to the next factor.
Tax Loss Harvesting
Odds are, not all your investments will make money. At some point, you’ll probably have one you need to get rid of at a loss.
But even a loss can have a silver lining because it can be used to offset gains in other areas and reduce your tax liability.
The process is called tax loss harvesting, and it’s a great way to unload investments that lost money. But it has to be accomplished strategically, and there are quite a few nuances.
So, like with all the other factors, it’s best to speak with a tax expert first.
The Bottom Line
Understanding tax implications and using strategies to minimize taxes can have a huge impact on your finances. And while this post is an excellent start to reducing taxes and using the savings to build your portfolio, there is much more to learn. So, find a good tax advisor, keep studying, and watch your nest egg grow!