Published in: Buying Stocks | May 9, 2019
By: Jordan Wathen
Whether or not a brokerage account is taxable depends on the type of account. Some retirement accounts can save you a fortune in taxes over time. Get all the details here.
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Picking good investments is half the battle of investing and growing wealth. The other half is investing in a tax-efficient manner so that you keep as much of your gains as possible. Depending on the type of brokerage account you use, income from capital gains, dividends, and interest may or may not be taxable.
Below, I’ll explore the tax issues with investing, and talk about some brokerage accounts that help you avoid taxes and tax headaches with your investments.
Some brokerage accounts provide protection against taxation when they are used as specific types of retirement accounts. Many people open individual retirement accounts (IRAs) at brokerage firms in order to shelter what they earn while investing from taxes until withdrawal, or forever.
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Deciding between a Roth or traditional IRA can be tricky because making the right choice involves predicting a number of different variables. To make a perfect decision, you’d need to know your income, marginal tax bracket, and investment returns, now and into the future. If you’re five years away from retirement, you can project these kinds of things with relative precision. If you’re 40 years from retirement, it’s not so easy.
A common rule of thumb is that younger investors are better suited for Roth IRAs, because they’re likely to earn more as they age, and could pay higher taxes in retirement than they do in the present. Roth IRAs also have some important advantages, like the ability to withdraw your contributions at any time for any reason without penalty, which is helpful if you need to withdraw money for an emergency, for example.
Soon-to-be retirees are likely in their prime earning years and may be paying higher taxes now than they will pay in retirement, thus making them better suited for a traditional IRA. Some people divide and conquer, putting part of their savings in a Roth account and another part in a traditional account so as to diversify their tax exposure. There isn’t a one-size-fits-all answer for how to approach Roth vs. traditional accounts.
Regardless of whether you choose Roth or traditional IRAs, tax-advantaged brokerage accounts have a huge advantage: You are only taxed on withdrawal (traditional IRAs) or before you make a contribution (Roth IRAs). In contrast, in a taxable brokerage account, you’ll owe taxes every time you sell an investment at a gain, collect a dividend payment, or receive interest on your balances.
Tax-advantaged accounts save you some trouble at tax time, and it’s likely you’ll come out ahead by deferring taxes with a traditional account or avoiding taxes on gains with a Roth account compared to using a taxable brokerage account.
An ordinary brokerage account that is not a retirement account is a taxable account. If you make money because your investments go up in value, or because your investments pay you dividends or interest, this income will be taxed. The taxes depend on the type and source of the gains or income you earn.
The most basic way to make money investing is the old-fashioned way by purchasing a stock, fund, or other investment and selling it later for more money. You know the mantra -- “buy low, sell high.”
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Money you earn from capital gains is taxed at different rates depending on how long you held the investment. Gains on investments you held for one year or less before selling them are “short-term capital gains,” which are taxed as ordinary income.
Holding an asset for more than one year gets you favorable tax treatment on the gains when you sell. For instance, if you buy a stock for $10, hold it for 18 months, and then sell it for $15, you will have $5 of long-term capital gains. Taxes on long-term capital gains can range from 0% to 20% depending on your tax bracket, but they are almost always lower than what you’d pay on short-term capital gains. This is to reward people for investing for the long haul rather than speculating on short-term price movements.
Companies often pay out a portion of their earnings in the form of cash dividends to their shareholders to reward them for being part owners of a profitable business. Income you earn from dividends is taxed in two different ways, depending on the type of dividend you receive.
When you earn interest on any investment from a bond, certificate of deposit, or just from holding cash in your brokerage account, the income is generally taxed as ordinary income. There are two common exceptions to this rule, however.
Any income you earn in a taxable brokerage account is taxable when the income is realized. If you sell a stock at a gain, that gain is taxable. If you earn interest on your cash balance, that interest income is taxable.
Many people falsely believe that any gains or income earned in a taxable brokerage account are not taxable until withdrawn, but that isn’t the case. What matters for taxable brokerage accounts is when the money is earned or gains are realized, not when it is withdrawn and enjoyed.
Most investors use taxable brokerage accounts only if they have already maxed out all of their tax-advantaged investment opportunities. For example, if you are currently maxing out a 401(k) at work, and an IRA you set up yourself, you might then consider opening a taxable brokerage account to save and invest even more money each year. If you’re maxing out your 401(k), but haven’t yet opened an IRA, an IRA is likely a better bet than a taxable brokerage account.
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