“Hey Andrew, I read your recent article on why people should consider Roth IRAs for investments. Regarding taxes, when would an independent brokerage account (taxable brokerage account) be taxed?”
The tax implications on taxable brokerage accounts aren’t very clear. I’ll explain it to you, but let me preface by insisting that I am not a tax professional and am just sharing my interpretation of the tax law. You should seek tax assistance or an accountant, as these laws change every year.
Taxes get triggered on your capital gains. Capital gains are achieved each time you sell a stock for a profit. The nice thing about taxes on gains is that you can offset them with losses. For example, if in one fiscal year you sold a stock for a $1,000 gain and also sold a stock for a -$750 loss, you’ll only get taxed for capital gains of $250. Keep in mind that tax events become triggered every single year in which you have capital gains.
Now you should also know that taxes will NOT be triggered if you are just holding a stock. Let’s say you hold a stock that has appreciated from $20 to $40 a share. As long as you haven’t sold that stock, you don’t have to pay taxes on it for that year.
Long and Short Term Capital Gains
When you do get taxed on your taxable brokerage account, there are two possibilities. One is that you get taxed for a short term capital gain and one is that you get taxed for long term capital gains. The short term capital gains are taxed much higher than long term. A short term capital gain is triggered on any stock that you sell and hold for less than one year. A long term capital gain can only be recorded if you’ve held the stock for more than a year.
As of 2014, short term capital gains were taxed at your ordinary tax bracket. Ouch. Long term capital gains were taxed at 0%, 15%, or 20%, depending on your tax bracket. Honestly I feel like I’ve seen these laws change so suddenly that it probably won’t stay exactly like this for long. You’ll have to constantly check every year. But this principle seems to hold firm: long term investors are favored over short term speculators.
Also keep in mind that the brokerage who serves you will not withhold taxes for you. IT IS YOUR COMPLETE RESPONSIBILITY TO TRACK YOUR CAPITAL GAINS AND PAY THEM DURING TAX SEASON. Sorry for the caps, but tax evasion is no funny business. Just ask the Giudices. You record any capital gains on your tax return along with the rest of your tax information, similar to deductible mortgage interest, your yearly annual salary or any other figure.
So if you are playing with stock market money in a taxable brokerage account, make sure you are sacking some of your gains away in anticipation of your tax bill. Just like paying taxes when running a small business, these numbers need to be organized, separated, and accounted for.
You can see how this can impede your progress towards wealth. Compounding slows down quite considerably when gains are taken right off the top and given to sweet old Uncle Sam. This is why you hear personal finance people always harping about IRAs and tax advantaged retirement accounts.
Taxable Brokerage Account: No Worry
In a tax advantaged account like a Roth IRA, the capital gains are allowed to grow tax free. You don’t have to set aside some of the winnings for a large tax bill every Spring, instead you can plow all of that money into a new investment. Even tax deferred accounts like a traditional IRA or 401k will let you reinvest that money without taxes for the time being, only charging you when you withdraw money from the account during retirement.
Taxes are definitely a tricky business when it comes to investing. Hopefully you can see why it’s such a hot button in politics. It’s not just the wealthy 1%-ers who pay up in taxes. Unfortunately even the hard working investors who are trying to improve their lot in life like you and me are subject to strict tax laws, and it’s a real obstacle to financial success.
That being said, don’t let this tax nonsense discourage you. It’s just another reason why I strongly advocate long term investing, and a slow and steady, patient approach.
If you’re doing this investing thing right, you shouldn’t be killed with taxes every year. Even in a taxable account, you should be reinvesting your dividends and waiting for the big payout years down the road. Remember that the secret to compounding interest in the stock market is dividend growth and reinvestment. Your reinvested dividends in a DRIP program won’t be taxed as you receive them. It’s the accumulation of shares from a long dividend holding that will get you rich, not constant buying and selling. If you need a reminder about this revisit the blog post about dividend reinvestment.
The investments we want will be cashed out 10, 15, 20, 25 years down the road after constant dividend increases. Those investments will give us yields on cost of 10%, 15%, 20%, 25% or more. Now that’s when serious wealth will happen… and at that point, they can tax me all they want. I’ll have plenty left over.