Brokerage accounts can be taxed depending on the type of account.
There are three main types of brokerage accounts: traditional retirement accounts, Roth retirement accounts and taxable nonretirement brokerage accounts. Each type of account receives a different tax treatment.
Retirement accounts are tax deferred, meaning you pay no taxes on any earnings within the account. Instead, you may owe taxes when you withdraw the money from the account. Nonretirement brokerage accounts — also called taxable brokerage accounts — don’t have the same tax-deferred advantage. In these accounts, “investment earnings and capital gains are taxable income to the account owner in the calendar year when they happen,” says Jeff Craig, senior wealth advisor and a principal of The Colony Group.
How Are Brokerage Accounts Taxed?
When you earn money in a taxable brokerage account, you must pay taxes on that money in the year it’s received, not when you withdraw it from the account. These earnings can come from realized capital gains, dividends or interest.
“When you sell a security like a stock for more than you bought it, the difference is taxed as a capital gain,” Craig says. For example, if you bought a share of stock for $100 then sell it for $150, you’ll owe taxes on the $50 of capital gains. How much tax you owe will depend on how long you held the investment.
“If you held the investment for one year or less, referred to as short-term capital gains, you’re taxed at your ordinary income tax rate,” says Matthew Erker, a certified public accountant, certified financial planner and advisor at Moneta, a partner-owned registered investment advisor firm. “However, if you held the investment for longer than one year, referred to as long-term capital gains, you’re taxed at the lower capital gains tax rate.”
[READ: What Is a Roth IRA?]
Both your ordinary income tax rate and capital gains tax rate depend on how much income you earn in the year. “There are seven different ordinary income tax brackets ranging from 10% to 37%, and three different capital gains tax rates ranging from 0% to 20%,” Erker says. Since the difference between the ordinary income tax rate and capital gains tax rates can be significant, he says it’s important to think carefully before selling an asset you’ve held for less than one year.
Taxpayers with modified adjusted gross incomes of more than $200,000 for single filers, more than $250,000 for married filing jointly or more than $125,000 for married filing separately may owe a 3.8% tax on net investment income earned during the year on top of their ordinary income or capital gains tax, Craig says.
Dividends received during the year are also taxed in the year they are received when the security is held in a taxable brokerage account. How dividends are taxed depends on if they’re qualified or ordinary nonqualified dividends. Ordinary dividends are taxed at ordinary income rates, while qualified dividends that meet certain IRS standards are taxed at lower rates. These standards include that you held the investment for more than 60 days and that the dividend is paid by a U.S. corporation or qualified foreign corporation. For more information on qualified dividends, see IRS Publication 550.
“If a dividend is qualified, it is subject to the same tax rates as long-term capital gains — 0%, 15% or 20% depending on your income,” Craig says.
Interest is another type of taxable investment income. “Interest can be earned on cash and fixed-income securities like bonds or bond mutual funds,” Craig says. Interest income is generally taxed as ordinary income.
With retirement accounts, taxation is a bit simpler. Traditional retirement accounts that are funded with pre-tax dollars are not taxed until the money is withdrawn from the account. You can generate as much capital gains, dividends or interest within the account and not have to pay any taxes. But you will need to pay ordinary income taxes on any money you withdraw from the account in the year you take the distribution.
Roth retirement accounts funded with after-tax dollars can be “tax-free,” Craig says. Similar to traditional retirement accounts, you pay no income tax on the earnings or capital gains received within the Roth, and if you meet certain requirements, such as having the account for at least five years, you won’t have to pay any taxes when you withdraw the money, either. This can make Roth accounts a great tool for minimizing investment taxes.
How to Minimize Brokerage Account Taxes
There are strategies investors can use to minimize the bite of brokerage account taxes.
The most obvious is to use tax-deferred retirement accounts whenever possible. Outside of retirement accounts, you can also minimize taxes by being strategic about when you sell investments. You can avoid the higher short-term capital gains tax rate by not selling appreciated investments until you’ve held them for more than one year.
Another strategy is to use tax-loss harvesting where you take capital losses on investments to offset capital gains. “If you sell a security for less than your cost basis, you have a capital loss,” Craig says. “You can use capital losses to reduce your capital gains, and if your losses exceed your gains, you can use up to $3,000 of losses to reduce ordinary income.” He suggests reviewing your portfolio each year for tax-loss harvesting opportunities.
“If the market or a certain investment is down, consider selling the asset and immediately purchasing a similar asset,” Erker says. “This ensures you stay invested in the market, and it allows you to book a loss you can use to offset future capital gains.”
You can also use tax-managed funds that focus on tax efficiency and may perform tax-loss harvesting as part of their strategy while also avoiding dividend-paying companies, Craig says.
All of this said, “while tax implications are extremely important to consider anytime you sell an asset, they shouldn’t necessarily drive investment decisions,” Erker says. “If you aren’t able to use any strategies to mitigate the tax burden, but it makes sense to sell the asset, do it and take the tax hit.”
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