How to Pay Taxes on Investment Income

Creating a strategy ahead of time can help investors avoid a huge federal tax bill in April.

Investors who sold profitable stocks in 2021 are facing a potential tax bill unless other investments that lost value were also divested. The tax on an individual’s investment income can be challenging to determine when the tax filing deadline arrives.

Here is a rundown on paying taxes on investment income:

— Withdrawals from tax-deferred accounts can be taxed.

— Be aware of capital gains taxes.

— Understand federal tax consequences.

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Withdrawals From Tax-Deferred Accounts Can Be Taxed

The earnings in tax-deferred accounts, such as 401(k)s; individual retirement accounts, known as IRAs; and health savings accounts, or HSAs, grow tax-free until withdrawals are made.

“When you take money out, you pay ordinary income tax on the amount of money you withdraw from the account,” says David Blain, CEO of New Bern, North Carolina-based BlueSky Wealth Advisors. You don’t have to take any out until you are 72 years of age (or 70 1/2, if you turned 70 1/2 before January 1, 2020).

An exception to these required minimum distributions, or RMDs, is the Roth IRA. “Roth IRA distributions are tax-free and there is no required date to take any money out,” he says. This is because Roth IRAs are funded with after-tax dollars. Contributions can be withdrawn tax- and penalty-free at any age. Earnings can be withdrawn without tax or penalty after age 59 1/2, as long as the account is at least five years old.

Other examples of tax-exempt income are municipal bond interest and return of capital distributions from master limited partnerships, says Michael Landsberg, a certified public accountant and principal at Homrich Berg Wealth Management in Atlanta. “Interest earned from U.S. Treasury securities are generally exempt at the state level, but fully taxable at the federal level.”

Be Aware of Capital Gains Taxes

A long-term capital gain is when an investment, such as a stock or exchange-traded fund, is owned for more than a year and a profit is earned, says Mike Loewengart, managing director of Investment Strategy for E-Trade from Morgan Stanley.

“Keep in mind how long you’ve owned the security and the amount in which you are selling it at since that will have an effect on the taxes you’re required to pay,” he says. “If you are selling investments at a loss, you can always offset your capital gains with losses to lower your tax bill in a move called tax-loss harvesting.”

For capital losses, tax-loss harvesting is a legal strategy to sell a stock that has experienced a loss in order to offset taxes on both capital gains and income.

Holding an investment like a stock for less than a year is a short-term capital gain and taxed as ordinary income, says John Blake, a CPA and a partner at Klatzkin in New Jersey.

The interest generated from certificates of deposit, money market funds and bonds is also taxed as ordinary income. The ordinary income tax rate can run as high as 37%.

Investors who sold their stocks last year at a profit are facing what could be a large tax bill if quarterly payments were not made. An individual taxpayer can deduct up to $3,000 of capital losses in excess of capital gains against ordinary income each year. The remainder is carried forward to offset next year’s gains.

Depending on your overall income tax bracket, long-term stock sales from investments you held for more than a year before selling are taxed at a rate of either zero, 15%, 20% or 23.8%, Blain says. Your federal capital gains tax rate depends on your income bracket from all sources of income, such as a salary, a stock sale or rental property.

“Don’t forget state taxes, since each state has its own tax laws. Some have capital gains tax and some tax it as ordinary income,” he says.

“Take your sales price minus your basis, which is the original purchase price, and the resulting gain is what is counted for income for tax purposes,” he says.

Some stocks make distributions through dividends, and investors who sold those equities will pay tax on the dividend income received while they had ownership. “Interest income is taxed at your ordinary income tax bracket, ranging from 12% up to 37% federal tax,” Blain says.

And don’t forget state taxes, he adds: “Some states tax interest income up to 13.3%.”

Understand Federal Tax Consequences

It’s good practice to set aside some money each month if you frequently buy and sell stocks, so you can avoid some of the sticker shock from the federal tax consequences.

“Most people are not great savers,” says Steve Wittenberg, a director of legacy planning at SEI Private Wealth Management. “It takes discipline to set aside money on a consistent basis for any purpose, especially taxes. The tax bill can become daunting when it comes to investing and making significant non-wage income.”

He says many wealth advisors will work with clients to earmark assets in a low-risk or liquid account in anticipation of larger tax bills. “This way, cash will be on hand when the IRS comes knocking,” he says.

Investors can adopt a few techniques to prepare and estimate how much to attempt to save. Some use the prior year’s tax return as a guide, especially if the investment income is expected to be consistent, Wittenberg says.

“If your tax situation is more complex and particularly inconsistent, it is highly recommended that a tax preparer make one or more tax projections to calculate the amount of tax that may be due,” Wittenberg says.

Many investors need to file quarterly payments to pay their taxes on time and avoid underpayment penalties, he says.

Experts say if the amount due is less than $50,000, a taxpayer should file IRS Form 9465 or apply online for an installment agreement.

“This is a fairly easy process: Take the balance due and divide by 75,” says Valrie Chambers, an associate professor of accounting and taxation at Stetson University in Florida. “Sign up to make this payment every month and acceptance of the taxpayer’s request is virtually guaranteed.”

The IRS will generally offer an installment agreement to a taxpayer to pay taxes over time, says Eric Bronnenkant, head of tax at Betterment in New York. “However, there will be interest assessed over the period of the installment agreement and possible additional fees. The other options include paying via credit card, which typically has a higher interest rate.”

Ultimately, the driving force on investment decisions should be the stock, and not the tax, Blain says. “I’ve seen people refuse to sell something because they didn’t want to pay the tax, or alternatively, trade too often and lose a good percentage of their gains to taxation.”

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