Investing Today, Taxing Tomorrow
Cashing out an asset can trigger more investment taxes than you might expect. But with the right strategy, you may be able to lower them.
Making a profit from an investment can be exciting—until the tax bill comes due.
Depending on the length of ownership and type of asset, taxes on investments can take a significant amount of money out of your pocket. Understanding how (and when) your investments are taxed is an essential part of your financial plan.
Tax-efficient investing strategies can benefit most investors, but those nearing retirement may be increasingly sensitive to the taxes associated with the sale of assets. No matter your retirement or investing timeline, learn how these strategies can help you make more mindful investment decisions.
Many people associate tax benefits with retirement accounts, or tax-advantaged investing. Tax-advantaged investments are either:
Tax-exempt. Qualified withdrawals from these accounts are not subject to tax. Examples include Roth IRAs and Roth 401(k) plans.
Tax-deferred. Initial contributions aren’t taxed, and withdrawals are taxed at your income tax rate. Examples include traditional IRAs and employer-sponsored retirement plans such as 401(k), 403(b), defined benefit and profit-sharing plans.
What Is Tax-Efficient Investing?
Tax-efficient investing may put more money in your pocket by cutting down on capital gains and income taxes. Efficient investments include retirement accounts, but also encompasses:
Exchange-traded funds (ETFs). Overall, ETFs have built-in tax advantages, making them appealing in retirement.
Bonds. Investing in municipal or Treasury bonds may be advantageous, as interest income isn’t always taxed at the federal level for Treasury bonds, and interest on municipal bonds is not subject to state or local tax.
Health Savings Accounts (HSAs). These accounts can be a great way to save for health expenses in retirement.
For those in or nearing retirement, when investment income is a priority, incorporating tax-efficient vehicles could translate into owing less in taxes, which can mean more money to meet expenses and invest for your future.
Leveling Up Your Investment Strategy: Tax-Loss Harvesting
Tax-loss harvesting could also help offset some of the capital gains with capital losses. That means if an investor reports capital losses from one investment, they could potentially offset gains from a different investment.
Tax-loss harvesting can get complicated, so it may be worth working with a financial advisor to learn more.
Compare investment options to help optimize your tax benefits and growth potential.
Understanding Common Investment Taxes
Tax-exempt and tax-deferred accounts may help investors cut down on taxes, but these accounts do come with annual contribution limits.
Those who want to invest beyond tax-exempt and tax-deferred vehicles should be mindful of the taxes associated with their investments. Because no matter how great a gain you make on an investment, taxes can significantly cut down on your bottom line.
You pay taxes on dividends in the year they pay out, even if the dividends are reinvested. The amount of tax owed on dividends will depend on whether they're qualified or nonqualified.
Nonqualified dividends are taxed at the same rate as the taxpayer’s income bracket. Nonqualified dividends include payouts from real estate investment trusts (REITs) as well as employee stock options.
A dividend is qualified if:
It’s paid out by a qualifying U.S. company or similar foreign business. Most publicly traded stocks, bonds, ETFs and mutual funds will fall into this category.
The asset it’s attached to has been owned for a certain period. Taxpayers must own the asset for at least 60 days during the 121-day period that starts 60 days before the ex-dividend date (you must own the stock at least a day before the ex-dividend date to receive the dividend).
If dividends are paid and reinvested within a tax-deferred vehicle like an IRA or qualified retirement plan, they are not taxed at the time the dividends are paid.
Capital Gains Taxes
When you sell an asset, profits from the sale are subject to capital gains taxes (unless the assets are held in a tax-deferred vehicle). Taxes will not be owed on the investment until it is sold, only when it becomes realized capital gains. Taxes are only applied to the profit from the investment, not the initial investment.
The tax rate for capital gains varies based on the time you hold onto an asset and your individual tax bracket. The higher short-term capital gains tax will apply if you hold onto an asset for less than a year.* In that case, your income tax rate determines the short-term capital gains tax.
But, if you hold onto the asset for more than a year, you’ll pay the lower long-term capital gains tax on the profits from the sale. Then you'll owe long-term capital gains tax, a tax rate of 0%, 15% or 20%, determined by your overall annual income.
Holding onto an asset for more than a year will benefit most taxpayers, as the gains aren’t taxed at the same rate as their ordinary income.
Qualified dividends are taxed at 0%, 15% or 20%, depending on the taxpayer’s income bracket. Investing in an asset that’s a qualified dividend can mean paying taxes at a lower rate.
Capital Gains for Mutual Fund Investments
Mutual funds are subject to taxes on capital gains and dividends. That means investors can owe capital gains taxes during the time they own a fund’s shares, as well as when they sell those shares at a profit. Holding on to a mutual fund for more than a year means paying the long-term capital gains rate. Similarly, if a mutual fund pays out dividends, choosing to invest in a fund that pays out qualified dividends could impact the tax rate.
Where an investor keeps their mutual funds can also impact taxes. Holding them in a retirement account can help defer taxes associated with interest and dividends.
A final consideration is your income tax rate. If gains from asset sales tip you into a higher income tax bracket, you’ll end up owing a higher amount on all their income. Understanding the federal income tax rate can give you an idea of how much you may owe if an asset sale pushes you into a higher earning bracket.
Selling an asset for a profit is exciting, but taxes owed may dampen the celebration, eating into your bottom line. Understanding how to reduce them can mean keeping more money for you.
A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you: Buy substantially identical stock or securities, acquire substantially identical stock or securities in a fully taxable trade, acquire a contract or option to buy substantially identical stock or securities, or acquire substantially identical stock for your individual retirement arrangement (IRA) or Roth IRA. See IRS Publication 550.
IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
Please consult your tax advisor for more detailed information regarding the Roth IRA or for advice regarding your individual situation.
Taxes are deferred until withdrawal if the requirements are met. A 10% penalty may be imposed for withdrawal prior to reaching age 59½.
IRA investment earnings are not taxed. Depending on the type of IRA and certain other factors, these earnings, as well as the original contributions, may be taxed at your ordinary income tax rate upon withdrawal. A 10% penalty may be imposed for early withdrawal before age 59½.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.