options. Because of their higher annual expenses, annuities generally make sense only if you won’t need the money for 15 or more years.
Selecting retirement account investments
When you establish a retirement account, you may not realize that the retirement account is simply a shell or shield that keeps the federal, state, and local governments from taxing your investment earnings each year. You choose what investments you want to hold inside your retirement account shell.
You may invest the money in your IRA or self-employed plan retirement account (SEP-IRAs and so on) in stocks, bonds, mutual funds, and some other common investments, including bank accounts. Mutual funds (offered in most employer-based plans) and exchange-traded funds (ETFs) are ideal choices because they offer diversification and professional management. See Book 5 for more on mutual funds and ETFs.
Chapter 2
Minimizing Your Taxes When Investing
IN THIS CHAPTER
You should pay attention to tax issues when making investing decisions. Actually, let’s rephrase that. Like plenty of other folks, you could ignore or pay half attention to taxes on your investments. Unless you enjoy paying more taxes, however, you should understand and consider tax ramifications when choosing and managing your investments over the years.
Tax considerations alone shouldn’t dictate how and where you invest your money. You should also weigh investment choices, your desire and the necessity to take risk, personal likes and dislikes, and the number of years you plan to hold the investment.
This chapter explains how the different components of investment returns are taxed. You find proven, up-to-date strategies to minimize your investment taxes and maximize your returns. Finally, you discover tax considerations when selling an investment.
Understanding Investment Taxes
When you invest outside tax-sheltered retirement accounts, the profits and distributions on your money are subject to taxation. (Distributions are taxed in the year that they are paid out; appreciation is taxed only when you sell an investment at a profit.) So the nonretirement-account investments that make sense for you depend (at least partly) on your tax situation.
Tracking taxation of investment distributions
The distributions that various investments pay out and the profits that you may make are often taxable, but in some cases, they’re not. It’s important to remember that it’s not what you make before taxes (pretax) on an investment that matters, but what you get to keep after taxes.
Municipal bonds, which state and local governments issue, pay interest that’s federally tax-free and also state-tax-free to residents in the state where the bond is issued. (For more on bonds, see Book 4.)
Taxation on your capital gains, which is the profit (sales price minus purchase price) on an investment, is computed under a unique federal taxation system. Investments held and then sold in less than one year at a profit generate what is called short-term capital gains, which are taxed at your normal marginal income tax rate (which is explained in the next section).
Profits from investments that you hold longer than 12 months and then sell at a profit generate what are called long-term capital gains. Under current tax law, these long-term gains are taxed at a maximum 20 percent rate, except for most folks in the two lowest income tax brackets: 10 percent and 12 percent. For these folks, the long-term capital gains tax rate is 0 percent (as in nothing). Dividends paid out on stock are also taxed at the same favorable long-term capital gains tax rates under current tax law.
The Patient Protection and Affordable Care Act (informally referred to as Obamacare) increased the tax rate on the net investment income for taxpayers with adjusted gross income above $200,000 (single return) or $250,000 (joint return). Net investment income includes interest, dividends, and capital gains. The increased tax rate is 3.8 percent.
Determining your tax bracket
Many folks don’t realize it, but the federal government (like most state governments) charges you different income tax rates for different parts of your annual income. You effectively pay less tax on the first dollars of your earnings and more tax on the last dollars of your earnings. As a wage earner receiving a paycheck, you won’t actually notice or see your actual tax rate rising during the year. The reason: Taxes are withheld at a constant rate from your paycheck based upon estimating your expected income for the year and your total expected tax bill for the year.
Your federal marginal income tax rate is the rate of tax that you pay on your last, or so-called highest, dollars of income (see Table 2-1). Your taxable income is the income that is left after taking allowed deductions on your return.
TABLE 2-1 2021 Federal Income Tax Rates for Single and Married Households Filing Jointly
| Federal Income Tax Rate | Singles Taxable Income | Married Filing Jointly Taxable Income |
|---|---|---|
| 10% | Up to $9,950 | Up to $19,900 |
| 12% | $9,951 to $40,525 | $19,901 to $81,050 |
| 22% | $40,526 to $86,375 | $81,051 to $172,750 |
| 24% | $86,376 to $164,925 | $172,751 to $329,850 |
| 32% | $164,926 to $209,425 | $329,851 to $418,850 |
| 35% | $209,426 to $523,600 | $418,851 to $628,300 |
| 37% | Over $523,600 | Over $628,300 |
Your
