The tax implications of investing can significantly impact your overall returns and financial planning. Specific tax rules vary by country and can be complex, but there are some general tax considerations for investors.
Knowing the different types of taxes will help you determine which taxes are at play for the investments that you’re considering. It will also affect your strategy for acquisition and when you decide to reallocate.
I highly recommend getting a qualified tax professional to do your taxes if you intend to invest in a variety of assets with different tax implications. To me it’s well worth the money and their fee may be a tax write-off.
Different Types of Taxes
Capital Gains Tax
When you sell an investment for more than its original purchase price, you realize a capital gain. Capital gains are generally subject to capital gains tax. The rate varies depending on how long you have held the investment.
Short-term capital gains are profits on a sale that was held for one year or less. Your gains are added to your regular income and taxed at your normal income rate based on your federal tax bracket.
Long-term capital gains are profits on a sale that was held for more than a year. Your gains are taxed at either 0%, 15% or 20% depending on your tax bracket. Most people will be in the 15% range.
Long-term capital gains tax rates are typically lower than short-term rates or your regular taxation rate.
Dividend Tax
Dividends received from stocks or certain funds are typically taxable. The tax treatment of dividends can vary based on whether they are qualified or non-qualified dividends.
Qualified dividends often receive more favorable tax rates, similar to long-term capital gains. Some countries may have preferential tax rates for qualified dividends, while others treat them as regular income.
Interest Income Tax
Interest earned from investments like bonds, savings accounts, or CDs is typically treated as ordinary income and taxed at your applicable income tax rate.
REITs, BDCs, and MLPs
Real Estate Investment Trusts and Business Development Corporations are required to distribute at least 90% of their taxable income to shareholders, which means investors typically receive regular dividends.
Master Limited Partnerships have a unique tax structure as well that acts similar to REITs and BDCs that allows them to pay quite a bit in dividends.
The tax treatment of the dividends for these assets can differ from that of regular dividends, and some portion may be considered non-qualified dividends or return of capital. That portion it typically taxed at regular income rates.
Foreign Investment Taxes
If you invest in assets outside your home country, you may need to consider tax treaties, foreign tax credits, or any withholding taxes on dividends or interest payments.
Withholding Tax
Some investments, such as foreign stocks or bonds, may have withholding taxes applied to dividends or interest payments by the country in which the investment is based.
Double taxation treaties between countries may affect the amount of withholding tax. Be sure to do your research beforehand.
This type of tax is a big consideration if you determine that diversifying into foreign markets aligns with your allocation strategy and financial goals.
Estate Tax
Upon your passing, your investments and overall estate may be subject to estate taxes or inheritance taxes in some jurisdictions.
Ways To Help Navigate Taxes
Keep Good Records
It’s essential to keep accurate records of your investment transactions and report them correctly on your tax return.
Failure to report investment income or capital gains accurately can lead to penalties and interest charges.
Most brokerage accounts provide the proper tax forms, such as 1099, 1099-DIV for dividends, or 1099-INT for interest. Mine typically run 50-60 pages in length.
If you implement cost-dollar averaging or frequently sell off partial positions, it might be beneficial to keep your own records for personal analysis and strategy implantation purposes.
Use Tax-Advantaged Accounts
Many countries offer tax-advantaged retirement accounts, like IRAs and 401(k)s (in the US) or Individual Savings Accounts (ISAs) (in the UK).
Contributions to these accounts may be tax-deductible (traditional accounts) or made with after-tax dollars (Roth accounts).
These accounts provide additional tax benefits, such as tax-deferred growth or tax-free withdrawals, depending on the account type and specific rules.
Buy Tax-Exempt Investments
Some investments, such as municipal bonds in the United States, offer tax-exempt interest income.
Interest earned from these investments is typically not subject to federal income tax, and in some cases, it may be exempt from state and local taxes as well.
Use Tax Efficiency Strategies
Being mindful of taxes when constructing your investment portfolio can enhance you tax efficiency.
For example, holding tax-efficient investments, such as index funds, in taxable accounts, and tax-inefficient investments, like bonds, in tax-advantaged accounts.
Another may be to completely mitigate the need to pay capital gains tax if you can finagle holding assets for over a year and keep your annual income below $44,625 (2023).
Tax Loss Harvesting
Investors may strategically sell losing investments to offset capital gains and potentially reduce their tax liability. This technique is known as tax loss harvesting.
To Sum Things Up
Now that you know the possible tax implications of investing, you can make better informed decisions. The type of asset you choose and your investment strategy will likely be impacted in some way by tax considerations.
That being said, taxes are a normal part of any income. Even the assets with the highest taxes are still just your normal tax rate if you were to work a job. I’ll take passive dividends at that rate all day to forgo a job.
Again I highly recommend hiring a professional to do your taxes, if you’re going to be investing. These returns are more complex than a W2 income and tax laws constantly change. I’d personally rather be hiking or biking.
