So you gained $25,000 in your investment portfolio? Do you know what your tax liability will be? Tax deferred and taxable investment accounts have different tax rates on investment gains. For instance, a taxable investment account (money you invest from discretionary income in a brokerage account such as Fidelity) will be taxed in the year the gain occurs. Let’s say you invest $20,000 of savings in a Fidelity account and double your money over the duration of years. In the sale year of the stocks, bonds or other securities, or as trades occur, the gains will be taxable at the current capital gain tax rates. The gain is the difference between cost basis and sale price.
Taxable investment accounts
Capital gain tax rates vary from taxpayer to taxpayer, depending on the adjusted gross income at time of filing. Typically, this rate will be 15%. Yet there are instances where the rate will be higher or lower. For tax payers in the 10% or 15% ordinary income tax bracket, capital gain rates will be zero. Sales of 1202 qualified small business stock, sales of collectibles (coins, art) are taxed at 28%, and portions of unrecaptured section 1250 property (rental real estate) will be taxed at 25%. Capital losses on sales of investments are limited to $3,000 per year to the extent they exceed capital gains. For taxpayers with adjusted gross incomes exceeding certain levels qualifying them for net investment income tax (NIIT), an additional 3.8% tax applies. If a tax payer is in the 39.6% tax bracket for years 2013 and later, a 20% capital gains tax rate applies.
If you earn $50,000 of W-2 wages, married filing jointly, and have $10,000 of capital gains on sale of stock, your tax on the capital gain will be effectively zero for federal purposes because you are in 15% tax bracket. In Pennsylvania you would still be taxed at the current nominal rate of 3.07%; relatively immaterial. If you earn $100,000 of W-2 earnings married filing jointly, and gain $10,000 on sale of stock investments your tax rates would 15% on the transactions or $1,500 for federal purposes.
Tax deferred investment accounts
IRAs and 401k’s are tax deferred investment accounts and the taxes on gains are deferred. This is not to say you don’t pay the tax. The tax is just deferred. For instance if you contribute $25,000 in the cost basis to your IRA, and say it doubles in value over the duration of years, when you sell the investment stock or bonds, etc, you pay no tax.
The gain is taxed at distribution on traditional IRAs and taxed before contribution on a ROTH IRA. 401k accounts are taxed on distribution as earnings on a FORM 1099-R. Let’s say you defer $100,000 of salary into a 401k account. You pay zero tax on those earnings in the year of contribution, yet when you distribute the money; you pay tax in that year at your current rate. The benefit of a 401k is that you hopefully are in a lower tax bracket when distributing savings than when contribution. In addition, gains are not taxable on 401ks until the gain is distributed. Tax deferred gains permit you to earn capital gains and pay zero tax until your distribute the money.
Summary
Investment account taxation can be either tax deferred or taxable. Discuss investment options with your advisor to choose investment options that make optimal sense for your specific investment horizon and personal outlooks.