by Shelley Seagler
Americans have been paying taxes on their earnings for almost 100 years. During that period of time, tax laws have continually changed and have certainly increased in their level of complexity. Although no one enjoys paying taxes, at Snider Advisors, we like to remind our clients that taxes are an inevitable part of making money – and you should never let the tax tail wag the investment dog.
However, that doesn’t mean you shouldn’t do your best to minimize the impact taxes will have on your investment returns. Your best bet to do this is to seek the guidance of a tax professional. You should also have, at the very minimum, a basic understanding of how your investments will be taxed.
The type of account you have will have the most impact on how the earnings you make on your investments will be taxed. If you have a tax-deferred account, like an IRA, you will not pay taxes until you withdraw funds. Any withdrawals you make after age 59½, including your Required Minimum Distribution, will be taxed at your ordinary tax rate. If you make withdrawals before you’re 59½, you will also most likely pay a 10% early withdrawal penalty.
Because Roth IRAs are funded with after-tax dollars, as long as you’re over the age of 59½ and the account is at least 5 years old, you will not pay taxes on your withdrawals. First-time home buyers can also withdraw up to $10,000 tax-free from a Roth IRA.
In a taxable account, you will pay taxes each year on the profits you earn. And in these accounts, timing is very important. If you sell an investment at a profit within one year of buying it, the income you make will be considered a short-term capital gain and you will be taxed at your ordinary income tax rate, which may be as high as 35%.
If you hold the investment longer than one year, your earnings will be considered a long-term capital gain and you will be taxed at the capital gain rate. The capital gain tax is currently no higher than 15% for most stocks and funds. However, beginning in 2013, those who are married filing jointly with a Modified Adjusted Gross Income (MAGI) over $250,000 and single filers with a MAGI above $200,000 will pay an additional 3.8% surtax, bringing their long-term capital gains rate up to a maximum of 18.8%. The capital gain tax rate also applies to capital gain distributions from mutual funds and most dividend payments.
Once again, it gets back to not allowing the tax tail wag the investment dog. Your investments don’t watch a calendar and they don’t know how long you’ve owned them. If a security gets to a target sell price, chances are you will be better off selling it, even if doing so means you will pay a higher tax rate.
Perhaps the second biggest factor in how you will be taxed is what type of investment you choose. Different types of investments are taxed differently. For example, the interest you earn on Municipal Bonds is free of federal income tax. And if you buy them in the state where you live, it is also free of state and local taxes. However, while Municipal Bonds may offer some advantages if you hold them in a taxable account, those advantages may be lost in a tax-qualified account. To make sure you are getting the maximum benefit from a particular investment, you should always consider how you will be taxed.
The most important thing to know about taxes is this – if you’re ever unsure about the tax implications of buying, selling, or holding a particular investment, consulting a tax professional is always your best move.