Happy #FinanceFriday ! I hope all of you have used the skills you’ve learned from reading these articles and started investing for your future. With Tax Day just behind us, its fitting discuss taxation on investments.
As with any income, Uncle Sam’s greedy self is there to take his share. If you earn dividends or sell investments and received cash, you have to pay taxes for your Return on Investment (ROI). There is a dual tax code:
- Earned Income: what you make in a job that shows up on a W-2
- The tax bracket range is 10-39.6%, with most people in the 25-28% range.
- The US has a progressive income tax system that only applies to earned income, the more you make the higher the percentage paid in taxes.
- 47% do NOT pay income tax; young workers, older people, and a family of 4 earning $50k or less. However, a family of 4 will still pay into social security.
- Investment Income: what you make on investments. Reportable investment income appears on a 1099 form.
- Interest: from investments like bonds and money market accounts. This is taxed at your income tax bracket.
- Dividends: These are NOT taxed at your income tax bracket. Most people pay a top rate of 15%
- Capital Gains: These are NOT taxed at your income tax bracket. Most people pay a top rate of 15%
The tax structure shows preferential treatment towards investment income and taxes it at a lower rate than earned income.
A capital gain occurs when you sell an investment for more than you paid for it. There are unrealized capital gains, which means the value of your investment has increased, but you have NOT sold the investment. If you do sell the investment at a rate that is higher than what you bought it for than it is a realized capital gain. A sale must take place for a tax liability to occur. Capital gains on short-term investments are less than a year and are taxed on your income tax bracket.
A capital loss can reduce your income tax bill, but the capital loss must be realized in order to do so. However, there is a catch, if you declare a capital loss on your taxes, you cannot buy back the same security for 31 days.
There are several types of investments that let you avoid paying taxes on your investments. The main types of tax-deferred accounts are IRAs, 401(k)s, 403(b)s. A 401(k) is a retirement plan through your employer and a 403(b) is an education retirement plan. The term tax-deferred means you pay taxes on your ROI when you retire and start pulling funds out of your retirement plan. There are two types of tax-free accounts/investments including: municipal bonds and Roth IRAs. We’ll talk more about retirement plans on next week’s #FinanceFriday.
I hope you learned a lot from this article and make sure you comment below with any questions you may have. See you next week!