Investing All-in-One For Dummies. Eric Tyson

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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

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