If you invest money and then sell your investments, hopefully, you’ll collect a return. If you do amass some extra cash, can you guess who else (besides you) will extend an outstretched hand?
That’s right. Uncle Sam.
The type of investment income you receive will determine how you’ll be taxed. If you suffer investment losses, you may be able to deduct these losses. It’s also possible to minimize your tax liability by investing in specific tax-advantaged accounts.
Understand the two types of dividends & how they're taxed
Dividends are payments to owners of stocks, ETFs or mutual funds. “Ordinary dividends” include both qualified and non-qualified dividends.
1. Qualified dividends
To be considered a qualified dividend, your dividend needs to be paid by a U.S. corporation or a foreign corporation traded on a U.S. stock exchange.
You must hold a share more than 60 days during the 120-day period beginning 60 days before the ex-dividend date.
In the case of preferred stock, you must hold it 90 days during the 180-day period beginning 90 days before the stock’s ex-dividend date. Qualified dividends are taxed at the capital gains tax rate.
Learn more about Capital Gains Taxes.
2. Unqualified dividends
On the other hand, are taxed at the higher income tax rate, because they don’t qualify for the lower rate. Some examples of unqualified dividends and their counterparts include real estate investment trusts (REITs), master limited partnerships (MLPs), employee stock options and money market accounts.
How short-term & long-term capital gains are taxed
When you sell your investments, you’re taxed on the profit you make on those investments. This can apply to other capital assets, too, including cars, boats, land and real estate. How they’ll be taxed will depend on whether they’re considered short-term or long-term capital gains. Taxation only applies to “realized” capital gains, not “unrealized” capital gains (profits that exist only on paper).
Short-term capital gains refer to the sale of any asset owned for less than a year and is usually taxed at taxpayers’ top marginal tax rate, or your ordinary income tax rate.
Long-term capital gains refers to investments held more than a year, and tax rates are 0%, 15% or 20%, depending on income amount and filing status.
How interest income is taxed
Interest income refers to income you receive from investing in bonds or cash investments and is based on your usual tax rate.
Dividends, capital gains and interest income are all reported on the 1099. See below for a full list of 1099 forms:
- 1099-B: Reports capital gains and losses
- 1099-DIV: Reports dividend income and capital gains distributions
- 1099-INT: Reports interest income
- 1099-R: Reports distributions from retirement accounts
- 1099-MISC: Reports substitute payments in lieu of dividends
- 1099-OID: Reports any original issue discount (OID) from debt obligations
- 1099-Q: Reports distributions from education savings accounts (ESAs) and 529 accounts
How tax-advantaged accounts are taxed
Tax-advantaged accounts refer to any type of investment that is exempt from taxation, are tax-deferred or offer other types of tax benefits. (They’re different than taxable accounts, which, most of the time, don’t offer nearly the tax benefits. These can include individual and joint investment accounts, bank accounts and money market mutual funds.)
There’s a whole division of personal finance dedicated to robust tax planning, which encourages you to use the tax code to your advantage. Tax-advantaged accounts are a mainstay in what some even call “tax hacking,” without the illegal activity, of course.
Here’s a quick road map to tax-advantaged savings with these easy-to-implement options. For most, all you need is a brokerage account:
- Roth IRAs: Deposits are made with after-tax dollars, which means you don’t pay any taxes on your money when you out your funds in retirement. However, there is a 10% penalty on early distributions on income earned.
- Traditional IRAs: These IRAs are tax-deductible and are treated as regular income for taxes if you withdraw at age 59 ½ or older. (You’ll be hit with a penalty if you withdraw before that age.)
- 401(k), 403(b), Solo 401(k)s: You don’t have to pay any taxes on your funds until retirement. Note: Most early withdrawals (those taken before age 59 1/2 ) are taxed as ordinary income, plus a 10% penalty fee.
- 529 College Savings Plan: States and educational institutions created tax-advantaged 529 college savings plans for college savers. When used for tuition, room, board and fees at qualified institutions, they are not subject to federal tax or (typically) state tax. Over 30 states offer a tax deduction for 529 contributions.
- Health Savings Account (HSA): You can deposit money tax-free, withdraw funds tax-free when you use them for a qualified medical expense and investment gains aren’t taxed, either, as long as you use them for a qualified medical expense. Furthermore, if you are retirement age, you can withdraw funds like a traditional IRA.
How capital losses get taxed
When your investments decrease in value, or more specifically, when you sell an investment for less than your purchase price or adjusted basis, capital losses incur. If the stock market takes a nosedive, you can recoup some losses at tax time, but again, you’ll only reap the reward if you sell your assets.
You can download the Schedule D form for both capital gains and losses on the IRS website.
How dividend reinvestments get taxed
If you choose to reinvest your dividends instead of take them as a payment, you’ll still need to pay taxes on those dividends that were reinvested during that particular tax year.
If you receive dividends during 2018, for example, you should receive a 1099-DIV statement, when you file in 2019, and this includes if you participate in a dividend reinvestment plan (DRIP). (A DRIP allows you to purchase more shares of the stock rather than a receiving cash dividend.)
What about tax-efficient investing?
For more information about tax-deferred accounts, taxable accounts, the best types of funds to hold in each and how taxes can impact the growth of a portfolio, check out the video by TD Ameritrade:
By now, you know that one of the most tax-efficient routes you can take is to piece together a smart portfolio to shield your money from Uncle Sam. However, many of these types of accounts are tax-deferred and aren’t liquid at all, which can be disadvantageous if you need cash quickly. That’s why taxable accounts are typically a major necessity for most investors.
Taxes are complicated, so your best bet is to consult a tax accountant or advisor for more information about how you can build the most advantageous portfolio for your personal situation.