As an investor, I view two main things as having the ability to impact my portfolio negatively: fees and taxes. (Yes, of course, market fluctuations can have a negative impact, but that is an area over which I have absolutely no control, and I can’t waste time worrying about it.)
Investors talk all the time about how to pick the lowest fee options.
All the hype about low fees has something to do with the increased favorability of low-cost ETFs and fee-free trades. And for many years, I focused my investments around keeping fees as low as possible, opting for Vanguard ETFs with extremely low expense ratios.
When it came to taxes, though, I was taught from a young age that they are a necessary evil that I couldn’t bypass or control in any way.
Until a few years ago, I never considered that there was potential to take the reins and manage my investments to become more tax-advantaged.
But as we roll into the throes of another tax season, it’s essential to talk about what this time of year means for investors. And to discuss how we can make the most out of our investments from a tax standpoint.
In this article, we’ll cover:
- How the tax code affects investors
- Tax implications of various investments
- How different investment income, sales, and accounts affect taxes
- How to file taxes with multiple investments
- Tips for filing taxes to maximize savings
How Tax Codes Impact Investors
The tax code consists of the thousands of pages that individuals or businesses have to follow when it comes time to turn over some of your hard-earned money to Uncle Sam.
And combing through the tax code would take a lifetime. The only thing investors really need to know is that the government wants a piece of your investments. That means interest and dividends, but also capital gains and real estate income.
If you pay a professional to do your taxes, you might think they should be the only ones concerned about your investments’ tax implications. But thinking like that means you may be missing out on opportunities to maximize earnings.
We pay a Certified Public Accountant (CPA) to take care of the intricacies of our household taxes.
CPAs offer accounting services that include tax prep, so they’re well-versed in all things related to tax codes. Ours handles tax preparation for us yearly at a nominal fee (which is especially worth it if you’re not a numbers person, like me.)
But as far as our investments are concerned, my husband and I do the decision-making, then turn over the results of those investments to our CPA for processing each spring.
So the CPA is the expert on the tax codes, but coming up with ways to maximize savings is on us.
Tax Implications of Investments
The first step for any investor is to figure out in what areas you may be impacted by taxes. If you have any of the below investments throughout the year, there will likely be tax implications:
- Money in interest-bearing savings accounts, money markets, or CDs
- Stocks, bonds, ETFs, or mutual funds
- Company stock or stock options
- Real estate, including rentals or home sales
For each of these types of investments, taxes will be dependent on:
- What type of income you received from an investment. Did you receive income in the form of rent, dividends, or interest?
- If you sold any investments. If so, taxes may increase depending on how long you owned it and if you sold at a gain or loss.
- The type of vehicle in which an investment is held. The amount of tax you’ll pay is directly related to the kind of account that holds your assets. For example, the tax implications differ if an ETF that is held in a Roth IRA vs. a 401(k) vs. a taxable brokerage account.
Investment Income and Taxes
The majority of income earned on investments will be tracked by the companies that manage assets. They then report the information to you in a neat little form.
You’ll notice that the majority of these forms begin with 1099. That’s because 1099 is a section of the IRS tax codes called “information reports,” aka you reporting your income information.
As an investor, you’ll want to be on the lookout for forms like:
- 1099-INT: This form reports interest income from bank accounts, CDs, or savings bonds.
- 1099-R: You’ll receive a 1099-R if you take a distribution from a retirement plan, including if you rolled a 401(k) into an IRA or similar transaction.
- 1099-DIV: This form tracks dividends and distributions. You might receive one from Vanguard, Robinhood, E-Trade, or wherever you manage your investments.
The values reflected on some of these forms can’t be changed. For example, if you keep an emergency fund in a high-yield savings account like I do, you’re going to be subject to pay taxes on the interest you earn.
The same goes for any dividends from stocks. It is what it is. But amounts on the 1099-DIV are more variable because it also considers impacts from selling investments.
Say you buy 100 shares of an ETF in a taxable brokerage account. That means you put in after-tax money to make the purchase.
The government takes their cut when you recognize growth in that account by selling those 100 shares at a higher price. The difference between what you put in and what you took out is referred to as capital gains which come in two flavors.
Long-term capital gains are the most tax advantageous. A gain from an asset’s sale like a home, stock, or bond is considered long-term if you held the asset for more than a year. The average tax for long-term gains is 15% or less.
You’re subject to pay short-term capital gains when you hold an asset for less than a year. And these gains are taxed in your regular bracket, which can be much higher, up to 37% in some instances.
Short-term gains are most likely to impact day traders or those who love to try and play the “buy low today, sell slightly higher next week” speculative kind of stock picking game.
As you can see, it’s rather advantageous from a tax standpoint to hold investments, and their gains, for longer periods when possible. Further, your taxes are going to be assessed based on what type of vehicle is holding them.
Tax Differences Depend on the Investment Vehicle
When I think about potential future gains, I like to set a conservative estimate that the money I put in today might get me between 4-6% over the next 20 years.
But the truth is, the same ETF in my taxable brokerage account and Roth IRA will not give me the same outcome 20 years from now.
When I go to remove those funds, differences in taxes determine how much I ultimately get.
This is the reason why leaning on tax-advantaged retirement accounts is a smart move for any investor. The most common types of investment vehicles with different impacts are:
- Pre-tax retirement accounts: Accounts like a traditional 401(k), 457, or IRA have a considerable benefit in tax-free growth. But when you think ahead to the balance of these accounts in retirement, you’ll also want to consider that you’ll need to pay a portion of that money back in taxes.While you may be in a lower tax bracket in your 60s or 70s, and you’ll have long-term capital gains on your side, you can still expect to give back anywhere between 10% and 25% depending on your overall income.
- Post-tax retirement accounts: These are the types of accounts where you want to back up the truck with a blatant disregard for taxes. That’s because if you’re using an account like a Roth IRA, you’ve already paid the IRS before you deposited funds. And there won’t be any taxes on growth or withdrawals as long as you wait until age 59½.
- Taxable brokerage accounts: These accounts are the ones that hit you with taxes yearly on any income. But they also offer the best opportunity to optimize.You’ll be responsible for paying taxes on any asset’s sales (unless you record a loss), but you can turn that to your advantage by focusing on keeping holdings for at least a year. That moves your capital gains from short-term to long-term at a much lower rate.
- Real estate: There are major tax implications for happenings around real estate. If you have a rental property, the income you receive will be taxable.The benefit of a rental property is that you can deduct expenses and depreciation to offset a portion of the income. If you sell a home that’s been your primary residence for 2 of the last 5 years, a portion of the gains are taxable. But there are ways to lower the burden by adding the cost of any extensive home improvements to the base price.
How to File Taxes with Multiple Investments
When you grow your portfolio to the point of managing multiple investments, you’ll want to be sure you’re highly organized when it comes to taxes.
What I’ve found can sometimes be the most considerable burden is simply remembering to gather forms for all the investment accounts I have.
There are various tax worksheets, like Schedule D (investment capital gains and losses) and E (rental real estate), that help you report gains or losses and determine how much you’ll need to pay.
Assuming you have all of the forms provided from various investments, this part might be time-consuming but relatively straightforward.
Filing Tips to Maximize Savings
Filing taxes can be a major headache. And that’s why I turn to a CPA who can work through all the nuances for me. But even though I use a tax professional, I do certain things to maximize my savings and decrease the typical tax season headache.
Maximize tax-advantaged investments like retirement plans
Tax-free growth or tax-free withdrawals with retirement accounts are an incredible advantage to any investment portfolio. And it’s critical to put funds in those accounts first to take advantage.
I’m sure to max out my Roth IRA contributions every year to take advantage of tax-free growth and eventual withdrawals. I then balance that account using a Solo 401(k) to reduce my taxable income today.
My preference is to use both Roth and traditional accounts so that I won’t face all of the tax burden later in life.
Opt for long-term gains when possible
Given a choice, always opt to hold investments as long as necessary to file long-term gains instead of short-term. That goes for investments held in a taxable brokerage account as well as real estate.
Stay Organized All Year Long
Taxes become way more of a burden than they need to be if you fail to stay organized throughout the year. You can head off a lot of the pain of gathering necessary tax information if you track throughout the year.
As a rental property owner, I keep a running spreadsheet to list all of my expenses and a folder for receipts.
We also keep a household spreadsheet of all investment accounts and how much money we put in throughout the year.
The Bottom Line
Tax season doesn’t need to be a scary time for investors. But it pays to understand how your investments may impact taxes and plan as much as you can ahead of time. You’ll be better off by remembering to:
- Seek out tax-advantaged accounts and max them out first.
- Opt for long-term capital gains when possible.
- Consult a professional tax planner for help if you need it, especially if you have a larger or more complex than average portfolio.
For years, I likely paid more than I needed to in taxes because I wasn’t optimizing.
Now I understand that even though taxes are a fact of life, I shouldn’t ignore them or assume my CPA will take care of things.
Investments are intended to make you the most money possible, and a few simple changes to your investment strategy can help ensure taxes don’t eat away at more growth than necessary.