Taxes pop up pretty much anywhere money’s involved. You owe them when you pay for stuff (sales tax), when you make money from your job (income tax), and — yep — when you invest, too.
We’re not tax pros, so we can’t tell you exactly what your tax situation will look like. But here’s a high-level overview of how taxes work when it comes to investing to help you get the gist of why you might owe them, and when.
Why you’ll pay taxes
Typically, you owe taxes whenever you’ve made money — or, in IRS speak, you’ve realized gains — from your investments. Meaning you’d owe taxes after selling an investment at a higher price than what you paid for it. (“You” is somewhat figurative here because we actually do the selling and buying for you, but more on this in a bit.)
This is the capital gains tax. Typically, your capital gains tax rate will depend on your household income and how long you owned the investment. Held onto that investment for a year or less? Then the IRS considers the money you made from selling it a short-term gain, and you’ll be taxed at your ordinary income tax rate. Depending on your tax bracket, this rate can be anywhere from 10% to 39.6%. If you held that investment for longer than a year, your profit from the sale is viewed as a long-term gain — and you’ll be taxed at a lower rate. That’s 15% for most people, though you might pay 0% or 20%; it really depends on your ordinary income tax rate.
So why would you need to sell an investment? At Ellevest, we sell the funds in your investment portfolio when you want to withdraw money from your account, when we’re rebalancing your portfolio, and / or we believe you should be invested in a different fund altogether.
The first reason is pretty self-explanatory — the money you’re withdrawing has to come from somewhere. To rebalance your portfolio, we buy and sell investments so that your portfolio’s asset allocation — its mix of stock, bond, and alternative funds — is where we want it to be. Market movements can shift your portfolio from its target asset allocation, so we rebalance your portfolio when the allocation strays too far. Finally, sometimes we swap out your funds for new ones because our analysis shows that the costs, risk levels, and / or diversification offer more benefits for your portfolio.
Dividends and interest
You’re also responsible for paying taxes on any income you earn in your portfolio from dividends or interest. Those are payments you get for being a shareholder, and some of the stocks or bonds that make up the funds in your portfolios pay them, which is how you end up with income.
Interest and “ordinary dividends” are taxed at your income tax rate (besides income from municipal bonds, which is exempt from federal taxes and might be exempt from state taxes depending on where you live). Meanwhile, “qualified dividends” — which have to meet specific IRS criteria — are taxed at the long-term capital gain rate.
When you’ll pay taxes
Taxable investment accounts
Generally speaking: If you make any money while investing in what’s called a “taxable investment account,” you’ll pay taxes on that money when you file that year’s income tax return. So if there were capital gains from a profitable sale in your portfolio, or you received a dividend payment, or an investment you owned earned interest, you can expect to owe taxes for investments in this type of account. (If you’re an Ellevest client, we’ll provide you with the tax forms you need for that.)
Also good to know: If sell an investment for less than you paid for it (aka you had a capital loss), that doesn’t add any taxes to your bill. In fact, it could actually lower your tax bill by offsetting some of the capital gains taxes you might owe.
However, individual retirement accounts (IRAs) and 401(k)s handle taxes differently because they’re tax-advantaged accounts. A traditional IRA or 401(k) is a tax-deferred account, so your contributions may be tax-deductible — depending on your income level for IRAs— and your investment earnings grow tax-free. Then, once you’re 59½ years old, your withdrawals are taxed as income (take out money earlier, and you may be hit with an added tax penalty).
With a Roth IRA or Roth 401(k), your contributions aren’t tax-deductible, but the upside is that you don’t pay any taxes on withdrawals (again, as long as you’re at least 59½). With Roth IRAs, you also have to have had the account for at least five years when you take out money. However, if your income level is too high, you won’t be eligible to make contributions to a Roth IRA.
How Ellevest keeps taxes in mind
At Ellevest, we’re constantly using tax-smart techniques on your behalf. This starts with the low-cost, tax-efficient funds we use across all of our investment portfolios. It continues with us being really intentional with the asset classes we put in taxable, non-retirement accounts because we want to use ones that minimize the odds of taxes eating into your potential returns. We also reinvest dividends and interest in a way that minimizes transactions, so you’re less likely to trigger a taxable event —which is IRS speak for “you’re going to owe taxes for this.” Lastly, while rebalancing your portfolio, we maximize losses and minimize your gains whenever possible to reduce your capital gains tax.
Taxes play a big role in the forecasts for each of your goals at Ellevest too. We account for the estimated impact of taxes — based on what your personal tax rate may look like over the years — while calculating your forecast to help you see how much after-tax money you may have for your goal when you’re done investing.
Also worth mentioning: Our focus on helping you reach your goals is a big reason why we don’t do automated tax loss harvesting. Automated tax loss harvesting is a strategy in which one sells investments that have declined in value and use those losses to offset any capital gains (and the taxes that come with them). Proponents say it lowers taxes and increases after-tax returns.
Sure, automated tax loss harvesting can lower your taxes … but only for the time being. This strategy almost always pushes your taxes back, so you’ll end up paying the IRS when you eventually withdraw your money — which is when you need as much money as you can get. Another fun fact about tax loss harvesting? It only eliminates taxes when you donate your investments to charity or pass them down to heirs, and you can get the same tax break by doing those things yourself. No tax loss harvesting necessary.
We’ll stick to minimizing your taxes the Ellevest way: with investment portfolios built with tax-smart techniques and forecasts that account for taxes — all so we can help you see and reach your goals.
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The information provided should not be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice.
The information provided does not take into account the specific objectives, financial situation or particular needs of any specific person.
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