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Tax Implications of Investing

How do taxes impact your investments?

Tax documents

If your money is invested in a non-qualified (taxable) account, any income your portfolio generates is subject to taxes. Having a good understanding of the tax implications can help you plan better so you can position your portfolio to minimize taxes and help you keep more of your returns.

Three Types of Investment Income

  • Interest

    Income derived from bank accounts such as checking, savings, money market deposit accounts, and certificates of deposit. Interest income is also generated by bonds which can be taxable or tax-free depending on who issued the bonds. Interest income is taxed at ordinary income tax rates; the rate you pay for most of your income, like wages. If you earned interest income in your investment portfolio, you would receive an IRS tax form 1099-INT from the financial institution or brokerage firm for tax filing purposes.

  • Dividends

    Income derived from ownership of stocks or mutual funds. Not all stocks pay dividends but when they do, it’s typically quarterly. You have a choice of reinvesting to buy additional shares or take the dividends as a cash payment. Both options are still taxable and are taxed differently depending on how they are classified. Ordinary dividends, just like interest income, is taxed at ordinary income tax rates. Qualified dividends are taxed at a lower capital gains rate. A 1099-DIV form will be sent by your brokerage or mutual fund company for tax filing purposes and will notate whether they are ordinary or qualified.

  • Capital gains

    Profit realized from selling your stock, bond, mutual fund, real estate, or any other investment. Similar to dividends, there are two categories of capital gains. With short-term gains, securities held for one year or less are taxed at ordinary income tax rates. For long-term gains, securities held for more than one year are taxed at a lower rate, which depends on your total taxable income. The IRS will tax you only on realized capital gains which come from selling the security. If you have unrealized gains (gains from the increase portfolio value) they are not taxable until they’re realized, or when you actually sell the security.

What are Capital Losses and are They Taxable?

The goal of investing is to earn a profit. But there may be instances where you may have to sell a security at a loss, or selling for a price that’s lower than what you paid for it (cost basis). The good news is you don’t have to pay taxes on the loss. You can use the loss to offset any capital gains you may have for that year. If you have any excess losses, these can be carried over to offset any future capital gains.

What is a wash sale?

A capital loss can be used to offset capital gains only if it is not considered a wash sale by IRS. A wash sale occurs when you sell a security at a loss and immediately buy the same or similar security within 30 days before or after you sell. IRS disallows losses generated by wash sales to prevent people from misusing the tax benefit.