This is the fifth step in our complete series of Getting Started Investing. If you’re a beginner who’s looking to make your first investment and build wealth for the future, then read on.
Everyone’s favorite subject: taxation. Don’t worry, it will be quick and almost painless! Taxes are definitely a consideration when it comes to investing. No one wants to pay more taxes than they have to!
The Three Types of Tax Breaks
There are three types of tax breaks. Not all of them are the same. In fact one can land you in with massive IRS fines and in jail! Know the differences between the three types.
Tax deferment: Deferring your taxes until a later date will minimize your current tax liability. Things like interest, dividends, and capital gains can grow tax-free until they are withdrawn by the investor. The most common tax-deferred account is a retirement account, like an IRA. Ideally, you will be making less during retirement (because you generally need less in retirement!), so your earnings will be taxed at a lower rate.
Tax avoidance: While it may sound a little shady, tax avoidance is totally legal. It is the process of taking advantage of all legal opportunities in the tax code to minimize your tax liability. An example of this trading up to a bigger investment property using the 1031 exchange process.
Tax evasion: While we encourage tax deferment and avoidance, tax evasion is illegal, and should never be practiced. Tax evasion is misrepresenting your finances in order to lower your tax liability — like not claiming all of your income or taking false or inflated deductions. This is unethical — don’t do it! Or else you might have the tax man showing up at your doorstep one day.
Let’s next about the two different types of investment accounts: taxable and tax advantage.
“Taxes are what we pay for civilized society.” — Oliver Wendell Holmes, Jr., U.S. Supreme Court Justice
Most financial planning recommends only to invest in tax deferred accounts. Though this isn’t always the case. There are a number of advantages when investing in taxable accounts.
So let’s break down which funds would be more appropriate in taxable accounts and and which would be best in tax-advantaged accounts.
These investments are more tax efficient than others, so it may be preferable to keep them in taxable accounts:
- Tax exempt municipal bonds
- Savings bonds
- Tax-managed funds (funds that purposely minimizes taxable events)
- Stock index funds
- Low-yield bonds and bond funds
Tax-Advantaged Accounts (Think Retirement Accounts)
These investments typically result in higher taxes, therefore, it is advantageous to keep them in tax-advantaged accounts:
- Balanced funds
- High-yield bonds
- Active stock funds and funds with high turnover
- Actively trading stocks (hold for less than one year)
- P2P Investment Accounts
For more information about tax-advantaged and taxable accounts, read Do You Need Everything in a Tax-Advantaged Account?.
Tax Rates Change Yearly
Tax rates regularly change from year to year. For 2015, the updated rates are:
- Long-Term Capital Gains & Dividends: 15% or 20% for single filers making $400,000+ or married filers making $450,000+
- Medicare surtax: 3.8%, only applies to single filers with a MAGI of $200,000+ and married filers with a MAGI of $250,000+
Capital Gains Income and Tax
Why does it matter if capital gains are long-term or short-term? One costs you more in taxes! By the way, short-term is considered less than a year. A year and day (or longer) is long-term. Let’s discuss the difference in taxation between the two:
Short-Term Gains: Taxed at your regular income rate
Long-Term Gains: Capped at 20% (as of 2015), an income rate of 15% or lower means you won’t pay any capital gains tax.As you can see, long-term gains often result in lower taxes than short-term gains. Make sure your investment account is setup to take a FIFO (first in, first out) approach when you are ready to sell! For more information on long-term and short-term capital gains, check out Are Those Long-Term Capital Gains, or Short-Term Gains?.
Many people can equate the joy of tax preparation with that of a root canal. Should you hire someone to take this headache off your hands? Maybe.
If you are someone with a simple 1040 with minimal schedules, you can probably do your own taxes competently. However, those with more complicated returns or business taxes may want to outsource. Why?
- Tax returns, especially complicated ones, are a major time suck. It may be beneficial to throw money at the problem so you can focus on the things that you want to do — like making more money or sleeping.
- You could neglect to report something. Not on purpose of course, but it’s easy to leave something out when preparing your taxes. An accountant will be more likely to report everything accurately.
- Do you really want to be your own defense if you get audited? If the IRS believes something is amiss on your return, your accountant will be there to guide you through everything and do most of the work.
- You can deduct the cost of tax preparation on your business return and sometimes on your personal return.
Check out When Should You Hire Someone Else To Do Your Taxes? for more information on the subject.