With tax brackets expected to rise again in 2024 thanks to the IRS’s annual inflation adjustment, understanding how your investments are taxed and how to minimize the impact of taxes is essential to keep more of your money in your own pocket.
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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.
How Are Capital Gains Taxed?
“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.
“The sale of an investment held for less than one year is treated as short-term capital gains and subject to taxation at ordinary income tax rates that can go as high as 37%,” says Dan Sudit, partner at Crewe Advisors. “The sale of an investment held for greater than one year is treated as long-term capital gains and subject to taxation at long-term capital gains tax rates that, like qualified dividends, are taxed at a favorable rate that can range from 0% to 20%.”
Both your ordinary income tax rate and capital gains tax rate depend on how much income you earn in the year. Since the difference between the ordinary income tax rate and capital gains tax rates can be significant, 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.
“There is also tax-exempt income, that is tax free for the IRS, but may be taxable on your state returns,” says Naomi Ganoe, managing director and private client service practice leader for CBIZ MHM.
She gives the example of an Ohio bond that produces interest income. “That tax-exempt income would be exempt from federal taxes and Ohio taxes. But if you file in New York for income taxes, Ohio tax-exempt interest would not (be) exempt from New York income taxes,” she says.
How Are Dividends Taxed?
Dividends 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 dividends, also known as 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.
How Is Interest Taxed?
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.
How Are Retirement Accounts Taxed?
With retirement accounts, taxation is a bit simpler. Traditional retirement accounts that are funded with pretax dollars are not taxed until the money is withdrawn from the account. You can generate unlimited 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. Individuals who think they may be in a lower tax bracket in retirement prefer to use traditional retirement accounts.
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.
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How to Minimize Brokerage Account Taxes
There are strategies investors can use to minimize 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. You can sell a security at a loss and use that amount to offset up to $3,000 of capital gains each year. Any losses you don’t use in a given tax year can be carried forward.
Craig suggests reviewing your portfolio each year for tax-loss harvesting opportunities.
Just be aware of the wash-sale rule, which states that if you sell one security at a loss and purchase the same or a substantially similar security within 30 days of the sale — either before or after — the loss is disallowed.
“It doesn’t matter where the investor sells or buys the asset; it can be sold in an account at one brokerage and repurchased at a different brokerage in a different account, but it is all treated the same for determining whether there is wash-sale rule exposure,” Sudit says. “If, however, a particular investment is sold at a gain, it can be repurchased at any time because the wash-sale rules only apply to recognizing losses.”
You can also use tax-managed funds that focus on tax efficiency and may perform tax-loss harvesting as part of their strategy while avoiding dividend-paying companies, Craig says.
Just be aware that tax-advantaged investments often have lower yields than their taxable counterparts, Ganoe says.
“You are able to deduct investment interest expense, if you have ordinary investment income,” she adds. “Other deductions that can minimize the taxes are the normal itemized deductions on schedule A or your standard deduction.”
All of this said, “planning around the tax consequences of investments is critical in yielding efficient results from your investments, but it is also wise to consider not letting the tax tail wag the investment dog,” Sudit says. “If you or your advisor have reason to sell a particular asset at a particular time, but you want to hold off doing so to avoid the tax consequences, you may minimize the tax consequences” — but as a result of the investment’s subsequent poor performance rather than from good planning.
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Are Brokerage Accounts Taxed? originally appeared on usnews.com
Update 11/20/23: This story was previously published at an earlier date and has been updated with new information.
