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The Tax Guide for First-Time Investors
Three tax rules every first-time investor should know
The Tax Guide for First-Time Investors
Three tax rules every first-time investor should know
When it comes to pursuing your lifelong monetary goals, it’s always a good idea to start investing. Doing so is an important step since it can help build long-term wealth while also providing a vehicle for your money to grow faster than inflation.
According to Schwab, about 15% of all stock investors began investing for the first time during the pandemic. For many first-time investors, considerations like how or what to invest in are often top-of-mind, but there’s more to the story when it comes to smart investment strategies. Taxes, for one, may not enter the calculus for the uninitiated despite their potential impact on your investment portfolio’s long-term success.
Depending on how you invest and the products you select, it’s important to consider the tax impact of your investment style. While easy to forget when you press "buy" for the first time, knowing these three wrinkles in the law when tax time arrives is key to easing your future investment tax burden.
Short- vs. long-term capital gains
How you invest will play a role in the taxes you pay. Oftentimes, the more you trade or buy and sell different stocks and mutual funds, the more you’ll pay in taxes.
The longer you hold investments, the less you’ll pay in what’s called capital gains tax — or the tax you pay on appreciation of your investments. For instance, if you bought a stock at $12 and sold it at $20, you would owe tax on your gain of $8. How much you owe the IRS depends on how long you held the stock before selling.
If you owned it for less than a year, then your profits would be subject to short-term capital gains. This tax rate is the same as your ordinary income. Say, for example, you make $80,000 a year as a single person. You will be taxed at a 22% tax rate, based on 2022 marginal tax brackets. If you sold stock or bonds that you held for less than a year, any profits would also be taxed at 22%.
The long-term capital gains rate is typically much lower for investors. This kicks in if you held the stock or bond for longer than one year. In that case, any profits are taxed at either 0%, 15% or 20%, and no higher. For that person making $80,000, any investment profits are taxed at a 15% level instead of the 22% mark they might otherwise face.
Embrace tax-deferred accounts
The more you invest in a taxable account, the more you’ll likely pay in taxes. That’s because anything you receive in the account — whether it be profits that you gain from selling, dividends the company provides you for investing, or a certain percentage of any stock the company buys back — will be taxed in the year that you receive the funds. Fortunately, you can delay the payment of these taxes by using tax-efficient accounts. This maneuver also helps you maximize the growth of your wealth over time.
Tax-efficient accounts come in two forms: tax-deferred or tax-exempt.
- Tax-Deferred: In these accounts, you don’t pay taxes on the money you invest until you withdraw the funds, ideally in retirement. As your investments grow, you don’t pay capital gains. When you do choose to withdraw, the taxes you pay are the same as ordinary income. If you’re in retirement, however, your ordinary income has likely fallen below your working levels, which provides a significant tax advantage over time. Traditional individual retirement accounts (IRAs) and 401(k)s have this design.
- Tax-Exempt: In these accounts, you pay taxes on the money that you invest as ordinary income. Once invested, the money can grow, tax-free, for the rest of your life. When you withdraw the funds at retirement, you don’t pay taxes on the distributions. Common accounts with this design include the Roth IRA.
Both types of accounts have rules about when you can withdraw funds (you must be over 59½ years old to withdraw without penalty), and there are limits on how much you can invest each year.
Cutting Your Losses
All investors hate losing money, but it is a reality many face at one point or another in their investment journeys. Fortunately, there are ways to minimize the damage — for instance, if you have investments in a taxable account, losses can be used to reduce your tax impact.
By selling some of your investments for a loss, you can use it to offset your gains. For example, if you sold one stock with a gain of $10 and sold another stock for a loss of $5, you can offset the tax you would owe on the gain.
Any stock you sell to offset a gain must also abide by the 30-day wash-sale rule. This states that you can’t buy the same or similar investment that you sold for a loss for at least 30 days after the sell. If you purchase it again before 30 days pass, then you can’t use the loss to offset your gains.
You can offset up to $3,000 per year using this tactic. Any amount you don’t use, you can then carry over each year until you offset all the losses on the sale.
It’s a winning strategy, one that many veteran investors employ.