Why Your Investment Tax Rate Matters in Retirement

The contents of this webpage should not be construed as tax advice. Please contact your tax professional.

Estimated Reading Time: 5.5 minutes

Key Takeaways:

  • As an investor, you should understand the difference between ordinary income tax rates and capital gains tax rates.
  • You may be able to lessen your tax bill from performing tax-loss harvesting in your taxable investment accounts.
  • Whether you will pay ordinary income tax rates or capital gains tax rates often depends on factors such as the type of income you’re receiving and how long you have held a security before selling it.

Most people don’t likes paying taxes. It doesn’t matter what the tax is for, or what kind of tax it is. Ask the majority of taxpayers if they would rather pay capital gains or ordinary income tax, and their response would likely be neither. But understanding the difference between the two taxes can significantly impact the likelihood of meeting your goals in retirement.

As a seasoned investor, you likely understand the importance of diversifying yourself across various securities. In your search for diversification, you may have considered a variety of different securities, ranging from common to exotic. These may include stocks, bonds, mutual funds, real estate investment trusts (REITs), Master Limited Partnerships (MLPs), annuities and maybe even Bitcoin or other cryptocurrencies.

All these investment instruments are subject to taxation. But how do you determine how they will be taxed? Are they subject to capital gains or ordinary income tax? The tax may vary depending on the asset in question, which is why knowing the difference is important.

Income Tax

Ordinary Income tax is a tax imposed by the government on businesses or individuals based on all taxable income they receive. Income tax is collected on many different forms of income. Taxable income includes, but is not limited to, salaries, commissions and short term investment income. The Internal Revenue Service (IRS) is responsible for collecting and enforcing the tax laws in the US.

The US imposes a progressive, tiered tax system where those who earn more are taxed at higher effective rates and those who earn less are taxed at lower effective rates. The US has different tax brackets for those who meet various income thresholds.  Although income tax rates may vary, if you receive less annual income as a retiree than you did in your working years, your tax rate may be lower than it was back then.  

Capital Gains Tax 

Capital gains tax is levied on profits from selling specific types of investment assets, such as stocks, bonds or real estate in a taxable account or outside a retirement account.

For certain assets, capital gains may be taxed differently according to whether you held the asset for more than a year (long-term capital gains) or not (short-term capital gains). Your short term capital gains are taxed at your ordinary income rate, while a long-term gain is often taxed at a lower long term capital gains rate.

As an equity investor, your goal is likely growing the value of your assets. However, some investors are hesitant to realize capital gains due to the additional tax burden. It’s a classic double-edged sword, though. Would you rather have the value of your account stay the same and pay fewer taxes or see your account value grow and incur an additional tax bill later?

In an attempt to lower your tax bill, you may look to take advantage of tax-loss harvesting in taxable accounts. Tax-loss harvesting is the selling of securities to realize losses to offset some of the gains you may have realized that year. However, before attempting to lower your tax bill, you should always consult a tax advisor to get advice specific to your situation.

Different Investments, Different Tax Rates

For some investments, the line between what qualifies as capital gains or income can get blurry. Do you know if your investment income and proceeds will be taxed as long term capital gains rates or ordinary income tax rates? Here we’ll highlight some common tax questions and answers to help clear some things up. However, the instruments we will describe are subject to complex state and federal (IRS) tax rules. We encourage you to talk to your tax advisor for clear answers with regard to how these tax laws will affect your specific investment income, capital gains tax rate, or any deduction, exemption or taxable-event variations that may apply depending on your taxpayer status.

Q: How are you taxed when you sell a stock?

A: Long term capital gains rates generally apply if you sell  a stock at a profit after holding it  for a year or more in a taxable account. This however does not apply to transactions within traditional retirement or tax-deferred accounts, as withdrawals will be taxed as ordinary income.  In addition, if you sell a stock and have owned it for less than a year, your profits from the sale are subject to your ordinary income tax rate.[i]

Q: How are dividends taxed?

A: Qualified dividends—the most common dividend paid to investors by US corporations—are taxed at a capital gains rate that varies based on your tax bracket. Non-qualified or ordinary dividends may be taxed as ordinary income.[ii]

Q: How is annuity income taxed?

A: Annuities can be complicated. It depends on whether you bought your annuity with pre-tax or after-tax money, what kind of annuity you hold (there are a few variations), and when you are taking withdrawals. A comprehensive answer to this topic exceeds the scope of this article, so it may be best to consult your tax advisor to get clear answers on these complicated insurance products.

Q: How are REITs taxed?

A: One of the most common indirect real estate investment vehicles is a real estate investment trust (REIT). REITs pool investor capital to purchase income-producing residential or commercial property. REITs aren’t taxed at the corporate level, and they generally must pay a certain percentage of their profits out to investors each year. Because of this setup, REIT investors typically pay taxes on income distributions at their ordinary individual tax rates.[iii]

Q: How are other non-traditional assets taxed?

A: Non-traditional investments like MLPs, precious metals and cryptocurrency all harbor tax complexities that may be specific to your situation. If you hold any of these investments in your portfolio, you should speak with your tax advisor on how they affect your tax picture.

Fisher Investments Can Help

Understanding the tax treatment of your investments can play a major role in building a retirement portfolio that aligns with your longer-term financial goals. Fisher Investments may be able to review your portfolio and recommend an asset allocation that we think is best for you, while taking into consideration your tax situation.

To learn more about how we can help, call and speak with one of our qualified representatives today.

[i] Source: Internal Revenue Service (IRS).  www.irs.gov/taxtopics/tc409.

[ii] Source: Internal Revenue Service (IRS). www.irs.gov/taxtopics/tc404.

[iii] Source: Internal Revenue Service (IRS), www.irs.gov/instructions/i1120rei.

Investing in securities involves a risk of loss. Past performance is never a guarantee of future returns. Investing in foreign stock markets involves additional risks, such as the risk of currency fluctuations.