How Taxes Work

Every investment you make has a tax consequence. Yet, how you navigate your tax bill should be specific to you.

The key is aligning your desired outcome with a specific solution. If you are going to have a healthy relationship with taxes you need to be educated about how they work.

In this blog, I am going to demystify taxes. Let's look at the 4 questions you are going to get answered in this blog.

1. How do your investment products affect your taxes?

2. What are capital gains taxes?

3. How is your portfolio income taxed?

4. How does your account type affect your taxes?

4 Tax Questions You Should Understand.

1) How do your investment products affect your taxes??

The first step in understanding tax efficiency is to understand what vehicles are out there and which are tax-efficient. Stocks and bonds are the two ways that you can own an investment.

Stock - This is the equity of a company.

Bond - This is the debt of a company.

They both have their place in a portfolio but let's look at the tax-efficient way to own investments.

How can you buy into stocks or bonds?

1. Individual Stocks or Bonds

2. Exchange Traded Funds (ETF's)

3. Mutual Funds

There are pros and cons to each of these in how you own them. When we look at taxes we want to own the investment that gives us the most amount of tax control.

We want to control these three questions:

1. When we are taxed?

2. What tax rate we are paying?

3. How much in taxes do we owe?

The best vehicles for control are individual stocks or ETFs. These investments give us control to compound and avoid taxes, while mutual funds do not.

Let's look at a real-world example.

Exchange Traded Fund:

If you own an ETF in your portfolio the only way you pay taxes is if you decide to sell shares. It doesn't matter if the fund manager buys and sells in the fund. The capital gains stay locked in your investment until you decide to realize gains.

Mutual Fund:

 If you own a mutual fund in your portfolio you pay taxes when the manager buys and sells inside of the fund. This causes capital gain distributions at the end of the year. These are taxes that you cannot control.

Tax-efficient investments start with the building blocks. Understand what you own and why you own it.

Here is a visual that shows the potential tax drag certain funds can have on your investments.

2) What are Capital Gains taxes?

Whether you own stocks or bonds you need to know how you are going to be taxed. An asset you own will be subject to capital gains taxes if you sell it in the future. There are two types of capital gains we need to unpack.

Long Term Capital Gains vs Short Term Captial Gains

Every asset you own will have fluctuations in the market. You need to understand how you are taxed if you decide to exit or sell an investment. Depending on how long you hold an investment will determine what tax rate you pay.

Long Term Capital Gains apply to investments you have held for more than 1 year.

Short Term Capital Gains apply to investments you have held for less than 1 year.

Now that you know the holding period let's look at the tax rates.

Long Term Capital Gains are taxed at capital gains rates. Maximum of 20%

Short Term Capital Gains are taxed at ordinary income rates. Maximum of 37%

With a 17% difference in tax rate knowing how long you have held an investment is a key to paying less in taxes.

*Capital gains can also a net investment income tax of 3.8% for some high earners

3) How is your portfolio income taxed?

Everyone loves passive income, including me. The income that you get for truly doing no work. The best passive income I have found is through investing in the stock market. Let's look at the different types of income you can receive. The two types we will unpack are dividends and interest.

Dividends - These are payments from holding an equity investment.

There are two types of dividends.

1. Qualified Dividends

2. Non-Qualified Dividends

They are taxed in two different ways.

1. Qualified dividends are taxed at long-term capital gains rates. Maximum of 20%.

2. Non-qualified dividends are taxed at ordinary income rates. Maximum of 37%.

Many factors will determine how a dividend is paid, but the most important thing to remember is that a dividend is qualified based on holding periods.

Interest - These are payments from holding a bond investment.

There are two types of interest.

1. Taxable Interest

2. Tax-Free Interest

Taxable interest is going to be paid when you hold a corporate bond. A corporate bond is when you are holding a liability on a public company. Easy examples of these companies are Apple, Microsoft, and Walmart. All of the interest paid to you will be taxed at ordinary income rates.

Tax-free interest is going to be paid when you hold a municipal bond. A municipal bond is when you are holding a liability on a municipality. Your school district needs a new HVAC system so they raise money through a municipal bond. All of the interest paid to you will be tax-free.

Getting income from an investment is great, but what matters is what you are keeping. I have seen many clients fall into the "yield trap". This is where they are being paid a high yield only to be paying 50% of it to the IRS.

4) How does your account type affect your taxes?

Which account to own investments in can be overwhelming. Although there are many types of accounts there are only 3 ways that can be taxed.

Here they are:

Tax-Deferred

These are investments that receive a tax benefit today but will require you to pay taxes in the future. These are the types of accounts that are tax-deferred.

1. 401(K)'s

2. 403(B)'s

3. IRA's

Each of these accounts has its place in financial planning but it is important to remember the pros and cons. The #1 pro is that you will receive a tax benefit today. The #1 con is that these funds will be tied up and can't be used until a certain time or event occurs.

Tax-Free

These are investments that grow tax-free and they come out tax-free. These are the types of accounts that are tax-free.

1. Roth IRA's

2. Roth 401(K)'s

3. HSA's

You are probably thinking what's the catch with these accounts? The #1 pro is that these accounts are tax-free. The #1 con is that these funds are tied up and can't be used until a certain time or event occurs.

This is where tax planning comes in handy. Tax-free accounts are all about delayed gratification while tax-deferred accounts get you a present-year benefit.

Taxable

This is your traditional brokerage account. The account that you will fill up with your savings post-tax. While there is often more talk about retirement accounts, taxable accounts are my favorite.

Here is why:

1. Provide instant liquidity

2. Create tax assets for the future

3. Ability to borrow against these funds

When you look at your portfolio today do you have diversification in these areas?

Managing how much you have in each tax bucket should be a driver in your financial plan. At Moment Private Wealth , we specialize in being financial advisors for athletes and entrepreneurs. For our clients, optimizing investment accounts is critical to ensuring we lower their lifetime tax bill.

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*Moment Private Wealth offers information on tax and estate planning that is general in nature. Tax and Legal advice are not provided by Moment Private Wealth. Consult an attorney or tax professional regarding your specific legal or tax situation.