My friends, I have good news and I have bad news.
The good news is that investment taxes are a lot simpler and easier than you may expect.
The bad news is that you’re about to hate your earned income by comparison.
To begin, gather ‘round for a story
T’was the tax season of 2019 (for 2018 taxes) and yours truly was an investing spring chicken.
I had put a few thousand dollars in a few different accounts, and I felt positively #adult about it. I was talking on the phone with my dad while strolling the aisles of Kroger for that week’s rations of potato chips and Oreos, explaining how I was so ahead of the game and had already filed my tax return.
“But have you gotten your 1099s yet?” he asked.
“What?” I replied, already scoffing that my dad clearly knew nothing of the tax wizard I was.
“Your 1099s. From your investment accounts,” he replied. Panic ensued.
“I have to pay taxes on those?” I asked, incredulous. Why didn’t anyone tell me?
…and that’s how I found out you have to pay taxes on your investment accounts! Surprise!
Luckily, I had so little that it wasn’t too harsh of a course correction, but the more you sock away in your investment accounts, the more crucial it becomes that you’re on top of reporting it.
You don’t have to worry about your 401(k)s and IRAs
While your traditional 401(k) and IRA are great tax deduction vehicles (and you should definitely fill out that portion of the tax software if it’s not automatically done for you), you aren’t taxed on them in the same way you are in taxable accounts. After all, that’s kinda the point – so don’t worry too much about growth in those accounts.
Same with your Roth accounts – because you paid the taxes on the income upfront then invested it, you generally won’t have to pay taxes on them again in retirement.
This is where the term “taxable” investing gets its name – it’s just everything that isn’t a tax-advantaged account.
What does this look like in practice?
If you have an investing goal or have any number of other countless “individual investing” or “joint investing” accounts over the last 12 months, it’s likely that you experienced some gain.
For example, if you invested $1,000 in January of 2020 and today you have $1,200, that $200 difference is your gain. Usually, for most index fund investors, their gains will be composed of two things:
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Capital gains (the asset went up in value; in other words, it’s worth more now than when you bought it)
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For example, you buy a share of a company that’s worth $20 per share when you buy it, and a year later it’s worth $25 per share – that $5 difference is a capital gain
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Dividends (think about this like a token of appreciation from a company; the company is essentially distributing its profits to shareholders, and some companies offer higher “dividend yields” than others, which essentially is the measure of what percentage of your share you’ll receive as a dividend)
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For example, if you buy a $20 share of a company that pays you a dividend of $1 per share, its dividend yield is 5%.
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Now, if you do nothing with that money and allow it to ride, you may not have to pay any taxes on the capital gains.
You only pay taxes on capital gains when you “realize” them, which essentially means selling the share at a gain (using the example above, if you sold your share that you bought for $20 at $25, you’re profiting that $5 gain and the IRS is going to wrap its grubby little paws around it).
(Now, if you sell at a loss, you can claim that too and you may be able to use the loss to offset some taxable income – but for the purposes of today’s post, we’re not going to get into the nitty gritty there.)
How capital gains are taxed, when you finally sell
So obviously you’re going to sell eventually – whether that’s in the short-term (unexpectedly) or in the long-term 15 years from now when you’re kissing Corporate America goodbye and signing up for tango lessons.
Here are two ways the capital gains may be taxed, depending on how long you held it:
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If you sell in less than 365 days (one year): You’ll pay your earned income marginal tax rate (in other words, your tax bracket rate) on the gain. This is definitely sub-optimal and should be avoided at all costs if possible.
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For example, if we had sold our $20 share at $25 after, say, six months, and we’re in the 24% tax bracket, we’d pay $1.20 in taxes on that gain. Gross. Of course, it’s still better than nothing – you’re still getting ahead – but you’re less ahead than you could be if you had waited or sold older shares first.
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If you sell after 365 days (one year): You’ll pay the capital gains and dividends tax rate on the income. Everyone is familiar with the regular tax brackets, and most of us are in the 22-24% range. The capital gains and dividends tax brackets are a lot easier to navigate and can be way more forgiving (that’s the good news about investing!).
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If you (as a single person) have $40,400 or less in declared income, you won’t pay any taxes on your long-term capital gains. That’s right. 0%.
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If you have between $40,401 and $445,850 in income (yep, that’s not a typo), you’ll pay 15%.
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And if you have more than $445,851 in income, you’ll pay 20%.
And that’s it. A little less convoluted than earned income taxation, huh?
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But let’s circle back to dividends
So if you’re cruising with your investment accounts and you’re in it for the long-term, you may be like, Cool, I’m good – I haven’t sold anything.
But those dividends will be taxed annually whether you reinvest them or not (that is, keep them in the account and set them to “reinvest” or withdraw them). You pay taxes regardless.
Normally, there are two types of dividends:
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Ordinary dividends are taxed like ordinary income (in other words, you’ll pay your marginal tax rate on these bad boys).
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Qualified dividends that meet certain requirements are taxed similarly to capital gains, using the more forgiving brackets described above.
Should taxes scare you from investing?
Well, would you turn down a raise because it means you’re going to pay more in taxes?
No, probably not.
Of course, the discussion above is a pretty decent support case for maximizing your 401(k) and Roth IRA contributions first – since the ongoing tax situation on those bad boys is pretty simple (and by simple, I mean you often don’t have to do or pay anything each year until you start using the 401(k) – but you can buy and sell in those accounts with reckless abandon, though I don’t advise it).
I have a slew of articles about why the 401(k) and Roth IRA should be treated like the Gordo and Miranda to your Lizzie, and I’ll link them below – but if you’re ready to begin taxable investing (read: you’re already contributing the maximum amounts allowed to your retirement accounts), I certainly wouldn’t let the taxes scare you away.
If you owe taxes on investment gains, that means you have investment gains – and that’s a beautiful thing. Of course, there are ways to help minimize the pain – first and foremost:
Try your best not to sell assets that you’ve had for less than a year.
That’s one great way to help minimize your tax liability on growth, since once you cross the one-year mark you’ll be dropped down into the sweet, sweet capital gains tax brackets.
What does this look like in practice?
It’s pretty simple: Most firms will send you something called a 1099-DIV at the end of January. This will list your capital gains, ordinary dividends, qualified dividends, etc. – and that’s what you’ll upload to your tax software of choice or give to a licensed tax advisor.
To give you a sense for scale, on an account that closed out 2020 with almost $60,000 invested, I had only $576 in ordinary dividends and $388 in qualified dividends.
Some quick math:
$576 * 24% (ordinary income tax rate) = $138
$388 * 15% (qualified dividends/capital gains tax rate) = $58
I’ll pay about $200 in taxes this year on an investment account that grew by approximately $6,500. Would I forego the investment opportunity because I don’t want to pay $200 in taxes? Of course not.
Firms like Betterment work to help make taxes really simple
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Betterment offers investment portfolios and automated tools that are designed with tax efficiency in mind. In other words, you don’t have to worry about accidentally selling something too soon without Betterment warning you that whatever you’re about to do could have a tax impact.
If you’re on the fence about investing, you may have perfectly valid reasons to feel gun-shy – but taxes shouldn’t be one of them.