One universal truth of investing is that there is always some degree of risk. However, it’s not just your principal at risk; any gains or losses that you may incur on an asset could also directly affect your taxes. The usual question asked is “How Do Investments Affect Taxes.”
Tax implications should be a substantial consideration when investing in the stock market as ownership of capital assets can have varied influences come tax time. Knowing this in advance can help you modify your investment strategies and ultimately form a better investment strategy. Keep in mind that if you fail to factor in the tax consequences of your investments, you may end up with much less than you planned. A SurePath financial advisor can help.
Every investment is going to show some form of loss or gain over time. These capital losses and gains will have an impact on your taxes. Let’s explore how do investments affect taxes and why your taxes can be affected by the assets you currently hold.
Where You Hold the Investments
Before you decide on the type of your investments, you have to decide on the account to hold them in. Should you go for a traditional or Roth IRA? Nonqualified account or retirement account? Your decision will have important tax implications both when you put money in and take money out. Most traditional retirement accounts give you a tax deduction on your contributions, and pay ordinary income tax on your withdrawals. Roth accounts do the opposite; you get no tax benefit for contributing, but all growth and withdrawals are tax-free. Taking a tax deduction right away may be more valuable for some, but for others, the tax-free withdrawals offer more benefits down the road.
What Types of Investments You Choose
The next step is choosing what type of investments to purchase. Investment income is taxed differently depending on the type of investment. For example, stocks may pay out dividends and if the dividends qualify, they receive preferential tax treatment (usually 15%). Bonds, on the other hand, pay interest, which is then taxed as ordinary income. Municipal bonds are unique as their interest is generally income tax-free. This makes them a good choice for investors in higher tax brackets. However, before buying, you should look at what type of income your investments will produce.
How You Trade Those Investments
Another way your investments affect your taxes is how often you buy and/or sell them. When you buy an investment, the goal is to buy low and sell high. This way you only have to pay taxes on the difference. This is called capital gains tax. Conversely, if you sell the investment for less than you bought it for, that is a capital loss. Tax rates on capital gains are lower than your ordinary income, which is the benefit of investing. But you only get this special rate if it is a long-term capital gain. This requires you to have held the investment for over a year before you sold it. In any other scenario, you pay short-term capital gains which are taxed at higher rates. In this sense a long-term approach increases your odds of success and decreases your taxes as opposed to constantly buying and selling.
Ways to Minimize Investment Related Taxes
Select Your Accounts Carefully: Choose between traditional accounts, Roth accounts or a combination of both with caution. When you’re planning your taxes ahead of time, you are potentially saving thousands of dollars in the long run.
Asset Location: Strategically diversify your investment portfolio with different assets in different accounts. Place investments with higher expected returns in taxable or Roth accounts to keep all growth tax-free. Place your lower expected return assets in tax-deferred accounts to add up to 75 basis points to your returns.
Avoid Day Trade: Constantly buying and selling means you end up paying higher taxes. One way to lower your tax bill is to take advantage of long-term capital gains. To do so, you need to buy an investment only if you plan on holding it for at least a year.
Avoid High Turnover Funds in Taxable Accounts: You may not be buying and selling all the time, but your mutual fund could be. This will pass all associated costs along to you. Index funds or tax-managed funds have lower turnover, which results in lower tax rates.
Tax Loss Harvest: This technique allows you to benefit from the natural ups and downs of the market, and generate tax savings while staying invested in it. You can offset future gains with losses, thereby reducing your tax consequences.
Managing taxes is just as important as picking the right investments for your financial success. Most people find that taxes take a larger piece of their portfolio than any down market will. Paying less in taxes results in higher net returns. Or, in other words, controlling taxes allows you to get the same net return with less risk. A SurePath financial advisor can help. Think of your investments and taxes as something that goes hand in hand. Design a comprehensive strategy and follow it to make the right financial moves with your capital.