With tax season fast approaching, now is a great time to brush up on some of the basics, including capital gains, different types of accounts, and recovering tax losses.
Are you ready ? Let’s start.
How are taxable brokerage accounts different from IRAs and other retirement accounts?
Taxable brokerage accounts can take many forms of ownership. They can be held alone, jointly with a partner, or even through a trust or organization. In these accounts, you invest taxable money, such as your paycheck. However, you may still have to pay taxes on future growth or income from these investments.
Traditional IRAs and Roth IRAs, as well as retirement plans like 401(k)s, are geared toward long-term saving and investing, so they get special tax treatment. Your contributions are either tax-deferred, meaning you don’t owe income tax until the distribution is made, or after-tax, meaning you already pay tax on the money you you contribute, so your qualifying distribution is tax-free. *
What is capital gains tax and when do I have to pay it? Capital gains tax is a government tax on profits from the sale of investments. In other words, if you sell an investment for more than you paid, you will pay capital gains tax on your income. Unless you are required to pay estimated taxes, you will pay capital gains tax when you file your tax return.
Let’s look at an example:
An investor buys 1 share of ABC Company for $10 in his taxable brokerage account. She then sold the stake for $15. The result is a realized capital gain of $5. Investors only pay capital gains tax on the $5 gain instead of the full $15. The first $10 is considered its “base” – the initial investment amount.
What does realized and unrealized mean?
You “realize” a capital gain when you sell your investments in a taxable brokerage account for more than you paid. If your investment appreciates and you don’t sell it, your gain is considered “unrealized”. You do not owe capital gains tax on unrealized gains.
Does it matter how long I hold my investment?
Yes, holding periods are important. Investors who hold investments for 1 year or more before selling at a profit are subject to long-term capital gains tax. Investors who hold the investment for less than a year before selling it for a profit will be taxed at the short-term capital gains rate. In order to encourage long-term investment, long-term capital gains receive special tax treatment. Most are taxed at 15% on the long-term capital gains they make. Investors subject to the short-term capital gains tax regime are taxed at the ordinary rate of income tax, generally above 15%.
What is tax-loss harvesting?
Tax loss harvesting is the intentional method of selling bonds at a loss to offset capital gains tax liabilities. Investors can use the harvest of tax losses when rebalancing their portfolios to reduce their tax liability. You can only reap losses in a taxable brokerage account. This strategy can be complex. If you would like to learn more about implementing this strategy, advisors at Vanguard Personal Advisor Services® can provide additional assistance.
Here is an example of tax-loss harvesting:
Assume the investor in the previous example did not sell his 1 share of company ABC for a profit of $5. Instead, she buys 1 share of XYZ Company for $15. This share of company XYZ then drops to $10, which costs him $5. If she sold both stocks, her capital gain would be $0 — a loss of $5 would offset a gain of $5.
Now imagine if she made a profit of $10 on 1 share of company ABC and lost another $5 on 1 share of company XYZ. If she sold both shares, her capital gain would be $5 — a $5 loss would offset part of the $10 gain. What if my losses are greater than my gains?
If you sell your investment for less than you originally paid, you may be entitled to a capital loss. A capital loss is the opposite of a capital gain. When an investment is sold for less than its original purchase price, the difference in value is considered a capital loss. Although we never want our investments to lose value, investors who realize a capital loss in their taxable brokerage account may be able to use that loss to reduce their taxable income or offset future capital gains. Income tax laws are complicated, but don’t be discouraged. If you need help or want to learn more, check out the articles and resources on our tax page. As always, we encourage all clients to seek advice from a qualified tax professional if necessary.