How to understand investment taxes
With tax season right around the corner, many people have questions about investment taxes. They are important to think about, but too often people shy away from investing because they’re worried about taxes. But once you understand how they work, you’ll see that investing can be a smart way to save money.
First, there is a difference between ordinary income tax (that’s the tax that is imposed on the salary you earn) and investment income tax (the tax you pay on money you make through the market returns). Investment income includes interest generated by bonds and dividends paid on stocks. When you sell such an investment for more than you bought it for, the difference is called capital gains, and is generally subject to capital gains tax.
Capital gains come in two buckets: there are short-term capital gains and long-term capital gains. Long-term capital gain results from selling investments held for more than a year, and, for now, is taxed at around 15% for the majority of taxpayers. This tax rate is relatively low as a way to incentivize taking some risk that naturally comes with investing.
Short-term capital gain refers to income earned on an investment held for a year or less. This gain is taxed at a relatively higher rate (similar to ordinary income tax), which is the government’s way of discouraging investors from flipping investments.
Individual circumstances vary, but here are some quick guidelines that apply to all but pretty unusual situations. If you can learn these guidelines to investment taxes, you’re in good shape.
Every kind of savings or investment account has taxes: You pay income tax on all realized investment income, whether it’s interest in a savings account, or dividends in your investment portfolio.
There are no circumstances under which you’ll be taxed more on a dollar of growth on your market investments than in a savings account. There are circumstances under which you’ll pay less tax on the same return in your investments, compared to a savings account.
You only pay capital gains tax when you sell an investment which has risen in value. If it falls in value and you sell it, you get a capital loss which can offset other gains, and you owe no tax.
You pay tax only on the gains, not on the full amount invested. If you invest $100, and it grows to $140, you’ll only owe tax on the $40.
Though the exact rate depends on your income and marginal tax rate, the most the federal government would tax you on gains from short-term investments (held for a year or less) is your ordinary income tax rate (plus 3.8% for more affluent taxpayers).
If it’s a long-term investment (held for more than a year), you’ll owe between 0% and 23.8% federal tax on the gain.
Note that individual circumstances may vary, and the above should not be construed as tax advice. Always consult your tax advisor.
Jon Stein is the founder and CEO of Betterment, a leading online investing company that delivers smart, personalized financial advice paired with low fees and a superb customer experience. As a special offer, Metro readers can start a Betterment with the first 90 days free. Got money questions? Hit us up at firstname.lastname@example.org.