Avoid Focusing Too Much on Investment Income Taxes


Estimated read time: 6 minutes

Key Takeaways:

  • Taxpayers may be impacted by where they invest and what they invest in
  • Capital gains are a part of asset growth and capital gains taxes may be unavoidable
  • While you might want to avoid taxes, making sure that you invest appropriately to meet your long-term needs and goals is most important

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.

How do Investment Accounts Affect Taxable Income?

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.

  • With a tax-exempt account, you pay income tax up front on contributions. Your subsequent withdrawals from your investments aren’t taxable. A common example of a tax-exempt account is a Roth IRA or Roth 401(K).
  • A tax-deferred account means your contributions are made pre-tax, which lowers your adjusted gross income in the year of your contributions. Upon retirement, however, your distributions are considered taxable income. Common examples of this type of account are traditional 401(k)s, 403(b)s and traditional IRAs.
  • Investing in a taxable investment account does not directly lower your tax rate or income tax in the years of contributions or withdrawals. However, it does offer a potential advantage if you implement a tax-loss harvesting strategy in these accounts. Tax-loss harvesting is selling stocks that have fallen in price to offset any capital gains taxes resulting from stocks that you have sold at a profit. You may also potentially use claimed losses to offset a portion of taxable income.

Capital Gains and Dividend Investment Income

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.

Investment Income Taxable Events

To better understand how taxes may impact your investment income in retirement, we now take a closer look at taxable events.

  • Roth conversion: If you convert your Traditional IRA into a Roth IRA, you will generally owe the IRS tax on your income for any untaxed amounts in your Traditional IRA.[i] You can pay income tax separately or directly from your account. This rule may also apply to conversions from a 401(k) to a Roth 401(k).
  • Capital gains: If you sell an asset for a profit, you have realized a capital gain. If you held the asset for more than a year, you may have to pay taxes on your long-term capital gains. If you held the asset for less than a year, you may be subject to short-term capital gains tax based on your ordinary income tax bracket.[ii]
  • Tax-loss harvesting: You can offset some of your capital gains taxes or even some ordinary income by writing off your security losses. Bear in mind that tax-loss harvesting applies only to taxable accounts. Also, be wary of re-purchasing the same or a similar security immediately after selling it, as that could violate the wash sale rule and render you unable to claim the loss.[iii]
  • Required Minimum Distributions: RMDs are taxed at your ordinary income tax rate.[iv] Be sure to withdraw the correct RMD amounts, on time, from your retirement account. Failing to do so may result in a tax penalty greater than the amount of tax you would typically pay on a withdrawal. So, even if you don’t need the withdrawals for income needs, you need to take the RMDs and pay the tax—you can reinvest your RMD withdrawals in a taxable account, or find another way to invest the money.

Why You Shouldn’t Focus Too Much on Taxes When Investing

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:

  • You may need to reallocate your assets to adjust to a different allocation or strategy.
  • You may need regular cash flow to supplement or enhance any income generated by bond coupons, Social Security benefits, real estate investments or pensions.
  • Your income needs may change during retirement, requiring a shift to align your asset allocation appropriately.

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.

Contact us for more information, or download a copy Your 2019 Tax Guide.

*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

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