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As the new year begins, you may receive a variety of tax forms from your financial service provider. So now is a good time to consider how your investments will be taxed. This kind of knowledge is helpful when paying taxes, but perhaps just as important, knowing the types of taxes generated can help you evaluate your overall investment strategy.
To understand the tax issues associated with investing, it is important to understand that investments typically result in capital gains or ordinary income. This distinction is meaningful because different tax rates may apply and taxes may be paid at different times.
So when do you pay capital gains tax or ordinary income tax on your investments?
When you sell an investment that has appreciated in value since you bought it, you receive a capital gain and pay taxes on that gain. Long-term capital gains (investments held for more than one year) are taxed at 0%, 15%, or 20% depending on income. Additionally, qualified dividends, which make up the majority of dividends paid by U.S. companies to investors, are taxed at the same rate as long-term capital gains. (Note that dividends are taxable even if you automatically reinvest them.)
On the other hand, you pay ordinary income tax on capital gains from the sale of valuable assets held within one year. You also pay ordinary income tax when you receive “ordinary” dividends. This dividend is paid when a shareholder purchases a company’s stock after the cutoff date (ex-dividend date) for receiving stock dividends.
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Ordinary income tax rates can be much higher than the top tax rate for long-term capital gains, so it can be more advantageous from a tax perspective to focus on investments that produce long-term capital gains. And the best strategy to do that is to buy quality investments and hold them for the long term. This also reduces the costs and fees associated with frequent buying and selling.
However, there is another development in the investment tax situation. This is because not all ordinary income is taxable, and even if it is, it may not be taxed immediately. The most common examples of this are tax-deferred accounts such as traditional IRAs and 401(k)s. Typically, when you withdraw money from these accounts in retirement, you pay taxes at your own tax rate, but because they were tax-deferred in previous years or decades, these accounts are tax-free. It can grow faster than the account you paid for. Every year. Therefore, it’s generally a good idea to make regular contributions to a tax-advantaged retirement account.
Finally, some investments and investment accounts are tax-free. Municipal bonds are not subject to federal income tax, and often state income taxes as well. Additionally, if you invest in a Roth IRA, your earnings can grow tax-free as long as you don’t start taking withdrawals until you’re at least age 59 1/2 and at least five years after opening the account.
At the end of the day, tax considerations shouldn’t be the primary factor in your investment choices. Nevertheless, knowing the tax implications of your investments, specifically, what types of taxes you may incur and when those taxes are due, can help you decide which investment options you are looking for. will help you assess whether it is suitable for your needs.
This article was written for use by Edward Jones Financial Advisors. Edward Jones, his affiliates and financial advisors do not provide tax or legal advice. Bret Hooper, Kevin Brubeck, Charlie Wick, Jeremy Lepore, Jessie Steinmetz and Mark Eaton are financial advisors to Edward Jones Investments and can be reached at 970-926-1728 or 970-446-0992 for Edwards and 970-328- for Eagle. receive. 0361, 970-328-0639 or 970-328-4959, for Avon he is 970-688-5420.
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