Your investment decisions could impact your tax bill. Learn about the basic rules and some strategies to help maximize after-tax returns and potentially reduce the amount you owe.
Taxes are a part of investing, and the way you build and manage your portfolio can potentially impact how much you owe. Here are some basic investment tax rules and strategies that may help you possibly reduce your tax bill.
Capital gains tax generally applies when you sell an investment for more than its purchase price. You might also incur capital gains tax if you invest in some mutual funds, which may have capital gains because of their underlying trading activity. The tax rate varies based on how long the security was held before it was sold. If it’s held for more than a year, it’s considered a long-term gain and the tax rate could reach 20%, depending on your income level. For most investors, the rate is likely to be 15%.
If an investment is sold within the first 12 months, it’s considered a short-term gain, which generally receives less favorable treatment. The gain is counted as ordinary income, and the tax rate may be as high as the marginal income tax rate, 37%. Many investors may face short-term rates between 22% and 32%.
Given the difference in investment taxation between the long- vs. the short-term, it's common for investors to hold securities for at least a year before selling if market conditions and investor goals make that possible. It could have a meaningful impact on your after-tax returns. In this way, investors facing the highest income tax rate could potentially reduce it from 37% to 20%, cutting their tax burden almost in half, again, if market conditions and investor goals don't require closing the trade earlier.
Of course, there may be times when you have a capital loss because an investment is sold for less than its purchase price. These losses are generally deductible, which may help reduce your taxable income. But there's a limit: Net capital losses may only offset up to $3000 of ordinary income per year.
Dividends are also usually subject to taxation. Here, too, the IRS uses different rates depending on the classification. “Qualified dividends” are true dividends according to the IRS, while “non-qualified” dividends include insurance premium rebates, credit union distributions, dividends from foreign investments, and co-op “dividends.” Almost all equity security distributions are considered qualified as long as the security is held for more than 61 days, but double-check before you file. Most likely, you’ll receive a 1099-DIV from your broker or other investment provider that shows the breakdown between qualified and non-qualified dividends. And remember, even automatically reinvested dividends may be taxable.
Qualified dividend tax rates may range from 15% to 20% for most investors. For high income earners, this rate can be meaningfully less than the tax rate on ordinary income.
Dividends and capital gains might be something to consider when comparing mutual funds. Investors wishing to mitigate the tax burden of owning a mutual fund may look for funds that meet their needs and also historically haven’t traded actively and thus made significant capital gains.
Keep in mind the past history of a mutual fund does not guarantee that the same policies or behaviors will continue, but it does give you at least an idea of how that investment has been managed in the recent past. Of course, for those investors looking for mutual funds that hold "blue chip" stocks or more income oriented stocks, dividend taxes may be unavoidable.
Also with tax implications worth considering are exchange-traded funds (ETFs). The tax implications on ETFs can be complicated and vary depending on the asset class and structure, but in general, an ETF investment isn’t taxed at the investor level until you sell it.
If you’re a full-time trader as defined by the IRS, you may be eligible for certain tax deductions that could help reduce the amount you owe.
Given the complexity of the tax rules for full-time traders, you might want to work with a tax advisor who can help you make more informed decisions based on your unique situation.
For investors and part-time traders, another tax minimization strategy might be tax-loss harvesting. With this strategy, an investor or financial professional, such as a TD Ameritrade Investment Management Portfolios Specialist, identifies a currently held security that has an unrealized loss. This security is sold, the loss is netted against other realized gains in the current tax year, and a similar but not substantially identical security is purchased. The tax loss is thus realized and “harvested” for the current year, while the portfolio retains similar securities.
To help satisfy IRS rules, the security that’s purchased must be different from the one sold. This requirement may be most easily met with ETFs or mutual funds. For example, selling a small-cap value ETF or mutual fund from one investment provider and purchasing a different one from another provider could meet this requirement.
Maintaining a tax-efficient investment portfolio may help you move forward. Don’t want to build your own? Consider a managed portfolio solution* from TD Ameritrade Investment Management, LLC.
The key to filing taxes is being prepared. TD Ameritrade provides information and resources to help you navigate tax season.
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