I’d like to present to you the US Tax Code. At 74,608 pages, it's a long book. To put that in perspective, the longest book in the Harry Potter series has 870 pages. The US Tax Code book tends to cause confusion as opposed to intrigue, and there's certainly nothing magical about it.
When you integrate a confusing, long, boring and (some believe) irrational book with investments, you have a recipe for confusion. So, allow me be your Albus Dumbledore and provide clarity to what you need to know about taxes and your investments. Let’s start with the basics.
There are three types of accounts to focus on:
- Taxable accounts - This would be an account you could hold joint with someone else or by yourself. These have no restrictions regarding how much you can contribute or withdrawal from the account every year.
- Tax Deferred Accounts- Your 401k, 403b, and rollover IRA would fall into this category. These accounts have restrictions on how much you can contribute, but the money goes into the accounts before taxes. This allows the money to grow tax-free and is only taxed when you take money out.
- ANALOGY: Imagine you could go into a gardening store and take a tomato plant out of the store without paying for it. You could then plant it wherever you wanted and watch it grow and produce many tomatoes. The moment you pick a tomato, though, you have to pay the gardening store. That’s sort of how these accounts work.
- Tax-Free Accounts- These would be your Roth IRA, 529 plan, and maybe your Health Savings Account (HSA). These accounts can have restrictions on how much you can contribute like the tax-deferred accounts. Unlike those accounts, though, the money in these goes in after tax, grows tax-free and is not taxed when you take money out.
- ANALOGY: This is your traditional transaction with a gardening store. You go in, buy your tomato plant, and pay at the cash register. Then you plant the bushes anywhere and enjoy the fruits of their labor without paying another dime.
Now let’s look at some of the investment events that can cause tax consequences:
- Dividends - These are cash flows that companies pay their investors. For instance, Apple stock has a dividend. This means if you bought the stock you would not only receive potential growth from the company creating the next best iPhone, but they would also pay you cash every quarter while you held the stock. These types of cash flows are taxed lower than what you are taxed on income you earn from working. The range of taxes on dividends could be from 0% - 20% based on what you are taxed on your income.
- Interest - These are cash flows that come from owning bonds, CDs or that ridiculously small interest earned on savings accounts at banks. This type of income is treated favorably. You have to pay taxes on these monies at the same rate you pay taxes on your income.
- Capital Gains - These are cash flows that are earned when you buy an investment and then sell it for a gain. For instance, if we bought Apple stock at $100 per share and sold it at $110 per share, we would be forced to pay taxes on the $10 we earned. If you buy and sell the stock within one year, then you have to pay taxes on your gain at the same rate you pay income taxes. If you buy the stock and then wait one year or more before selling then you will pay taxes at a lower rate, typically between 15-20%.
- Withdrawal- This would be when you take money from a retirement account. These monies are taxed at your ordinary income tax rate.
Let’s now take the types of accounts and the different types of taxes to create clarity on how each investment account works from a tax standpoint.
- The Taxable Account: You would have to pay dividend taxes, interest taxes and capital gains taxes on monies invested in this account every year.
- The Tax-Deferred Account: You don’t have to worry about dividends, capital gains or interest taxes in this account. All you have to worry about is paying taxes when money is withdrawn from this account.
- The Tax-Free Account: You don’t have to worry about dividends, capital gains, interest taxes or having to pay taxes on withdrawals from the account.
Now, we have been talking a lot about making money and how we don’t get to keep all of what we make. What about when you lose money in an investment? Well, on investments where you invested more money than you generated when selling the investment you have two options.
The first option is to use these losses to offset taxes from gains that you earned in that particular year. The second option is to utilize these losses in $3,000 increments in future years to help offset taxes.
Let’s walk through the first option of using losses to offset capital gains taxes for that year. Say you own Apple and Google stock in your investment portfolio, and you sell both stocks on the same day. Apple generated a profit of $100 which you would have to pay capital gains taxes on while Google generated a loss of $75 dollars. Well, you can now use your losses from Google to offset your gains from Apple leaving you to pay taxes on only $25 ($100 in gains minus $75 in losses), rather than on $100.
The catch with both options regarding losses on your investments is that this only matters to investments within taxable accounts, NOT tax-deferred or tax-free accounts.
The tax code is confusing already, and we add more pages every year. Regardless of your feelings towards the tax codes, though, we must all play by the rules, so hopefully the above will provide you some clarity into how the tax code’s magic trick with investments is performed.
In the month of February, Wela is teaming up with Barron Barnes, CPA of Capital Accounting & Tax LLC to write about taxes. Barron has extensive experience in business consulting and financing as well as corporate, partnership and individual income tax planning. He has been involved in both the audit and tax planning work for manufacturing and real estate companies and has clients in many different industries including real estate, architecture, interior design, equipment sales and leasing, printing, lumber manufacturing, advertising, film production and wholesale supply. If you have tax-related questions, you can reach out to Capital Accounting & Tax at (404) 947-7400.