How earnings are taxed on investments depends on whether the investments are held in a taxable or tax-deferred retirement account.
Earnings in tax-deferred retirement vehicles, such as 401(k) plans and traditional individual retirement accounts (IRAs), grow tax deferred until withdrawn. (Withdrawals, if made before age 59.5, may be subject to a 10% federal tax penalty. When the funds are withdrawn, all income is taxed at ordinary income tax rates, even income attributable to long-term capital gains and dividend income.
In taxable accounts, the long-term capital gains tax rate is 15% (0% for taxpayers in the 10% or 15% tax bracket), while short-term capital gains are taxed at ordinary income tax rates (10%, 15%, 25%, 28%, 33%, or 35%). Dividend income received by individual taxpayers from a domestic or qualified foreign corporation is also taxed at the same rate as long-term capital gains.
Thus, the difference between the maximum ordinary income tax rate (35%) and the rate on long-term capital gains and dividend income (15%) is 20%. This is a significant difference that could impact your decisions regarding how to invest your savings. Thus, consider the following strategies:
- Stocks that generate dividend income may best be held in taxable accounts. While you will have to pay income taxes as the dividend income is received, you will only pay tax of 15%. If the stocks are held in a tax-deferred account, you will pay ordinary income taxes on the dividend income when withdrawn.
- Consider holding growth stocks in your taxable account. Again, any long-term capital gains are taxed at 15%. If the stocks are held in a tax-deferred account, ordinary income taxes will be paid on the long-term gains when the funds are withdrawn. However, if your holding period is long enough, the deferral of taxes over many years may more than offset the higher tax rate.
- Investments generating ordinary income, such as bonds, should be considered for your tax-deferred account. Since ordinary income taxes will be paid whether the investment is held in a taxable or tax-deferred account, you delay the payment of those taxes by holding the investment in a tax-deferred account.
- The lower income tax rates for long-term capital gains and dividend income will reduce your tax bill in your taxable account, but you shouldn't quit contributing to your 401(k) plan or traditional deductible IRA. Contributions to those accounts are made from pretax dollars. Money invested in a taxable account is made with after-tax funds, so you'll only be investing 65 or 75 cents instead of the dollar that would be going into your 401(k) plan or IRA. That difference makes a tax-deferred account tough to beat over the long term.
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