One of the biggest questions people have around investing is do I have to pay taxes on investments? As we all know, when you make money, you usually owe taxes. There is a lot to understand and unpack around this topic, and a lot of it depends on what kind of investments you have. Some taxes are due only when you sell investments at a profit, while other taxes are due when your investments pay you a distribution called dividends. There are also tax-advantaged investment accounts like IRAs and 529 accounts that come with their very own set of rules. Let’s dive in!
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Taxes On Capital Gains
Capital gains are the profits from a sale of an asset — say a stock or a house. And they are considered taxable income. Now remember, the capital gains are the amount you have made on the sale, not the amount of the total sale. Let’s say you made a $10,000 profit when you sold Amazon stock, the capital gain would just be for the $10,000 not for the entire amount of stock you have sold.
The tax rate on capital gains for most assets held for more than one year is between 0 to 20%. Capital gains taxes on most assets held for less than a year correspond to ordinary income tax rates. Now, here is where it gets tricky, and it can be beneficial to have some tax help: Some people offset capital gains tax by using a strategy called tax-loss harvesting. What is this exactly? Let’s say at the same time you sold that Amazon stock for a $10,000 profit you sold another stock at a $10,000 loss. The loss would offset the gains, and you wouldn’t be required to pay any capital gains tax.
Taxes On Dividends
For a little refresher, dividends are the sums of money paid by certain companies to stockholders (typically quarterly) from its profits or reserves. For that reason, companies that pay dividends tend to be well established. As far as taxes on dividends go, they are usually taxable the year that you receive them. Of note, even if you automatically reinvest your dividends you still have to report them on your taxes.
It’s also important to note that there are two kinds of dividends — qualified and unqualified. You’ll be taxed on non-qualified dividends at the same rate as your regular income. For qualified dividends, you’ll be taxed between 0 to 20% depending on your taxable income and filing status. As for how to know what to report on your taxes? You’ll receive a 1099-DIV or a Schedule K-1 form if you received $10 in dividends or above so you can report this income.
Taxes On 401(k) Investments
The big reason why so many people suggest investing money in a 401(k) is for the most part you don’t pay taxes on the money you put in, and while the money is in the account you don’t pay taxes on investment gains, interest or dividends. The taxes do eventually hit when you make a withdrawal. For traditional 401(k)s, the money you withdraw is taxable as regular income — like income from a job — in the year you take the distribution. If you withdraw money from a traditional 401(k) before age 59½, you will likely have to pay a 10% penalty on top of the taxes unless you qualify for an exception. You may also have to pay a penalty if you wait past the age of 72 to make a withdrawal.
Taxes On IRA Investments
Similar to a 401(k) investment, IRA investment accounts are tax-advantaged brokerage accounts. With a Traditional IRA the tax situation is the same as it is for a 401(k), see above. With a Roth IRA, you pay the taxes upfront, and then your qualified distributions in retirement are not taxable.
Taxes On ETF And Mutual Funds Investments
Taxes On 529 Plans
Just a refresher, 529 plans are investment accounts used for education savings. They come with a lot of tax benefits. Most states allow you to deduct your 529 plan contributions on your state income tax return up to a certain limit. The earnings in the account are deferred from federal and usually state taxes. You also won’t be taxed on the money you withdraw for qualified education expenses. That means if you use your earnings from this type of account to pay for qualified education expenses you won’t have to pay taxes.
Taxes On A House Sale
If you sell your house at a profit your gain is taxable, though the IRS usually lets you exclude $250,000 of capital gains on a primary residence if you are single, and $500,000 if you are married and filing jointly. For example, say you buy a house for $400,000 and sell it for $800,000 as a single person — only $150,000 of that would be taxed.
Common FAQs On Paying Taxes On Investments
If You Don’t Sell Stock Do You Have To Pay Taxes On It?
It’s important to remember that no matter how much a stock you own goes up in value, you don’t pay taxes on it until you actually sell your shares.
What If You Don’t Report Your Investment Income?
Your brokerage reports your gains and losses — and also sends you a tax form for your records. Because an error on your taxes will probably cause suspicion, the IRS might choose to ding you for the error or you could even face an audit.
How Do People Avoid Paying Taxes On Their Investment Income?
There are lots of strategies to try to bring down your tax bill on capital gains. For one, some people invest in municipal bonds because they aren’t taxed. Other learn how to tax harvest. For most people the strategy is to max out their tax-advantaged accounts like the IRA.
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