Estimated read time: 6 minutes
When it comes to investing for retirement, the last thing you want is to allow the costs of investment income taxes to derail your long-term financial goals.* In other words, don’t let the tax “tail” wag the investment “dog.” Try to think beyond just the short-term taxpayer impact when investing.
Capital gains taxes are a part of a healthy asset investment strategy. There is a trade-off between paying taxes now and shifting your investment allocations to seek better returns later. A large tax bill for capital gains or investment income may hurt in the short term, but it is likely a manageable price to pay to achieve better long-term results.
Where do you hold your investments? Whether you have tax-advantaged accounts to provide retirement income, or taxable accounts, you should know how the differences can affect you.
When you sell a security that has risen above your original purchase price—selling at a gain—you may be subject to a capital gains tax. Depending on your tax bracket, your capital gains tax rate can be as high as your ordinary income level for securities held less than a year (short-term capital gains) or at a variable lower level for securities held over a year (long-term capital gains).
Many investors and taxpayers might not respond favorably to the prospect of paying more income tax. But capital gains should not automatically be looked at negatively. Capital gains are an inherent part of portfolio growth and investing. Capital gains are a result from your assets growing—and portfolio growth may be needed to fund your retirement.
Additionally, in order to position a portfolio for your appropriate level of growth and risk, an investor may have to occasionally rebalance assets. For example, this could involve selling a portion of stocks to reallocate your funds to bonds, cash or other assets that may be better suited to your situation. Although you may not want to pay more in capital gains tax, keeping your portfolio in line with your retirement needs is more important.
What about investment income from other sources, such as income from dividends? Dividend income doesn’t fall within the capital gains category, but it adds to your net realized investment income as a dividend payment, which may increase your net investment income tax. This may receive the same taxation treatment based on your adjusted gross income, which could vary with your income tax bracket and personal tax rate. Unlike taxation for capital gains, which may be avoidable by refusing to sell appreciated stocks, your taxable income from dividends is not dependent on selling assets.
To better understand how taxes may impact your investment income in retirement, we now take a closer look at taxable events.
Taxes are an inherent and often unavoidable part of investing. Some tax scenarios and strategies might offer good options to reduce your tax bill. However, taxes are not the only thing to consider when planning for retirement.
When it comes to creating your retirement portfolio strategy, time horizon, cash flow needs and inflation are all key factors to consider. Specifically:
Making these adjustments to keep your portfolio aligned with your goals may incur capital gains taxes if you are selling appreciated assets. But it is important to look beyond just the short-term tax implications and consider the best moves to meet both your short-term and long-term needs. Being tax-efficient wherever possible is smart. But don’t let tax considerations distract you from longer-term goals. Your financial goals and objectives for retirement should play a much bigger role in your decision-making process than the desire to avoid capital gains taxes.
*The contents of this webpage should not be construed as tax advice. Please contact your tax professional.
[i] Source: Internal Revenue Service, as of 2/14/2019. https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras-rollovers-and-roth-conversions
[ii] Source: Internal Revenue Service, as of 2/14/2019. https://www.irs.gov/taxtopics/tc409
[iii] Source: U.S. Securities and Exchange Commission, as of 2/14/2019. https://www.investor.gov/additional-resources/general-resources/glossary/wash-sales
[iv] Source: Internal Revenue Service, as of 2/14/2019. https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions