Whether a brokerage account is taxable or not is determined by the kind of account you hold. Some retirement accounts can save you a significant amount of money in taxes over time. Investing in brokerage accounts is a smart way to grow your wealth and secure your financial future. But as with any investment, it’s essential to understand the tax implications involved. In this blog post, we’ll dive into the question that many investors ask: Are brokerage accounts taxable?
When it comes to investing and generating money, selecting solid assets is only half the battle. The second half is investing in a tax-efficient manner to ensure that you retain as much of your gains as feasible. Income from capital gains, dividends, and interest may or may not be taxed depending on the kind of brokerage account.
Read on to discover everything you need to know about the taxability of brokerage accounts and how you can navigate this aspect of investing with confidence.
Understanding Brokerage Account Taxation
When it comes to brokerage accounts, taxes can be a bit complex. The tax treatment of your brokerage account depends on several factors, including the type of account and the investments held within it.
Brokerage accounts are taxed differently based on the kind of account you have.
Traditional retirement accounts, Roth retirement accounts, and taxable nonretirement brokerage accounts are the three basic types of brokerage accounts. Each type of account has a unique tax treatment.
Retirement accounts are tax-deferred, which means that any earnings within the account are tax-free. Instead, when you take the funds from the account, you may be required to pay taxes. Nonretirement brokerage accounts, often known as taxable brokerage accounts, do not provide the same tax-deferred benefit. “Investment earnings and capital gains are taxable income to the account owner in the calendar year when they happen,” explains Jeff Craig, senior wealth adviser and principal of The Colony Group.
In general, the answer to the question that many investors seek is: Yes, brokerage accounts are taxable because they are considered investment accounts. This means that any income generated from investments held in your brokerage account may be subject to taxes. However, the specific tax treatment will vary depending on the type of income and the length of time you hold the investments.
There are some important points to consider, as explained below:
Dividends: If your investments pay dividends, these earnings are typically subject to income tax. However, qualified dividends may be taxed at a lower rate.
Companies frequently pay out a percentage of their revenues to shareholders in the form of cash dividends to reward them for being part owners of a thriving firm. Dividend income from stocks and mutual funds is taxed in two ways. Dividends are taxed differently depending on the type of dividend received.
- Qualified dividends: Qualified dividends account for the vast majority of dividends paid by publicly traded companies. This implies they are taxable as long-term capital gains. There are certain restrictions governing how long you must own a stock in order to benefit from the reduced tax rate on qualifying dividends. The important point to remember is that qualifying dividends are taxed at reduced long-term capital gains rates.
- Unqualified dividends: Some companies do not pay corporation taxes on their revenues, the dividends they give to shareholders are called as “unqualified dividends” that are taxed as ordinary income. This is true for real estate investment trusts (REITs), master limited partnerships (MLPs), and business development corporations (BDCs) in general.
Capital Gains: When you sell an investment for a profit, you’ll incur capital gains tax. The tax rate will depend on how long you held the investment. If you held it for less than a year, it will be considered a short-term capital gain and taxed at your ordinary income tax rate. If you held it for more than a year, it will be considered a long-term capital gain and taxed at a lower rate.
The most fundamental approach to earn money investing is the old-fashioned one: buy a stock, fund, or other form of investment and then sell it for a profit. You must have heard this “buy low & sell high.”
Capital gains are taxed at varying rates based on how long you owned the investment. Gains on investments kept for one year or less before selling them are referred to as “short-term capital gains.” Short-term profits from brokerage accounts are taxed like regular income.
When you hold an asset for more than a year, you obtain preferential tax treatment on the gains when you sell it. For example, if you buy a stock for $10, keep it for 18 months, and then sell it for $15, your long-term capital gains will be $5. Long-term capital gains tax rates can range from 0% to 20%, depending on your tax bracket. They are, however, invariably lower than the tax on short-term capital gains or regular taxable income. This is to encourage individuals to invest for the long term rather than betting on short-term price fluctuations.
Taxable brokerage accounts
A taxable investment account is a regular brokerage account but not a retirement account. A taxable investment account is a good way to buy and sell assets like bonds, stocks and exchange-traded funds (ETFs).
If you gain money because your investments increase in value or give you dividends or interest, this income will be taxed. The taxation of brokerage account income is determined on the kind and source of the profits or investment income. Unlike retirement funds, however, you can withdraw from your taxable brokerage account whenever you choose, without penalty.
Tax-advantaged brokerage accounts
Some brokerage accounts, such as certain types of retirement accounts, offer tax protection. Many people open individual retirement accounts (IRAs) with brokerage companies in order to avoid paying taxes on brokerage account investments until withdrawal or for the rest of their lives.
Tax-deferred accounts. One of the most prevalent forms of tax-deferred brokerage accounts is the traditional IRA. Traditional IRAs are funded with pre-tax cash, and the money withdrawn in retirement is subject to regular income taxes. You might employ tax-deferred accounts to take advantage of tax arbitrage. Assume you are now in the 24% marginal tax bracket and anticipate being in the 12% marginal tax bracket when you retire. It makes sense to use a conventional IRA to avoid paying 24% on current contributions and pay only 12% on future withdrawals. (The majority of 401(k), 403(b), and other employer-sponsored accounts are also tax-deferred.)
Tax-free accounts. One of the most prominent types of tax-free retirement accounts is the Roth IRA. You contribute after-tax money to a Roth IRA, and any withdrawals you make in retirement are not taxed. Even if you had $5 million in earnings in a Roth IRA, you could withdraw them tax-free in retirement. You must pay close attention to Roth IRA income restrictions. These factors may exclude some people from utilizing a Roth IRA to save for retirement. It’s also worth noting that certain workplace retirement plans, such as a Roth 401(k), include Roth choices.
Whether you pick Roth or traditional IRAs, investing in a tax-advantaged account provides you with a significant advantage: you are only taxed when you withdraw (traditional IRAs) or make a contribution (Roth IRAs). In contrast, you will owe taxes on brokerage account earnings at every stage of a taxable brokerage account
Interest income
Interest earned on any investment, whether a bond, certificate of deposit, or just storing funds in your brokerage account, is normally taxed as ordinary income. However, there are two common exceptions to this rule.
US Treasuries – If you lend money to the US government by purchasing US Treasuries, your income is taxed at the federal level but is not subjected to state or local level taxation.
Municipal bonds – Interest earned from municipal bond is normally exempted from taxation at federal level and, in many situations, also exempt from state and local taxes.
How Are Brokerage Accounts Taxed?
When you make money in a taxable brokerage account, you need to pay taxes on it in the year you receive it, not when you withdraw it. These profits might come from capital gains, dividends, or interest.
“When you sell a security, such as a stock, for more than what you paid for it, the difference is taxed as a capital gain,” Craig explains. For example, if you buy a stock for $100 and sell it for $150, you need to pay taxes on the $50 capital gain. The amount of tax you owe will be determined by how long you owned the investment.
Your regular income tax rate and capital gains tax rate are both determined by your annual income. “There are seven different ordinary income tax brackets ranging from 10% to 37%, and three different capital gains tax rates ranging from 0% to 20%,” explains Erker. As the difference between ordinary income and capital gains tax rates might be immense, he advises thinking hard before selling an asset held for less than a year.
According to Craig, taxpayers with modified adjusted gross incomes of more than $200,000 for single filers, more than $250,000 for married filing jointly, or more than $125,000 for married filing separately may be subject to a 3.8% tax on net investment income earned during full year in addition to their ordinary income or capital gains tax.
When a security is kept in a taxable brokerage account, dividends earned during the year are likewise taxed in the year they are received. Dividends are taxed differently depending on whether they are qualified or regular nonqualified dividends. Ordinary dividends are taxed at ordinary income rates, but qualified dividends are taxed at reduced rates if they fulfill specific IRS criteria. These requirements include holding the investment for more than 60 days and the dividend being paid by a U.S. business or a qualifying foreign corporation. See IRS Publication 550 for further information on eligible dividends.
“If a dividend is qualified, it is subject to the same tax rates as long-term capital gains – 0%, 15%, or 20% depending on your income,” Craig explains.
Another sort of taxable investment income is interest. “Interest can be earned on cash and fixed-income securities like bonds or bond mutual funds,” explains Craig. In most cases, interest income is taxed like ordinary income.
Taxation on retirement accounts is little easier. Traditional retirement accounts funded with pre-tax earnings are not taxed until the funds are withdrawn. You can earn as much capital gains, dividends, or interest as you like within the account without paying any taxes. However, any money you withdraw from the account in the year you take the distribution will be subject to regular income taxes.
Roth Individual Retirement Accounts (IRAs) developed using after-tax dollars can be “tax-free,” according to Craig. You pay no income tax on the profits or capital gains earned within the Roth, and if you fulfill certain standards, like as keeping the account for at least five years, you won’t have to pay any taxes when you withdraw the money, either. As a result, Roth accounts may be an excellent option for reducing investment taxes.
When you pay taxes on a taxable brokerage account
Income earned in a taxable brokerage account is taxed when income is realized. If you sell a stock for a profit, the profit is taxed. If you earn interest on your cash balance, it is taxable in the tax year in which it is received.
Many individuals assume that any gains or income made in a taxable brokerage account are not taxed until they are withdrawn, but this is not true. You must pay taxes on brokerage account income in the tax year in which it is earned. For taxable brokerage accounts, what matters is when the money is generated or profits are recognized, not when it is withdrawn and enjoyed.
Most investors only utilize taxable brokerage accounts after they have exhausted all of their tax-advantaged investing options. For example, if you have a 401(k) at work and an IRA that you set up yourself, you may want to consider creating a taxable brokerage account. This might enable you to save and invest more money each year. If you’ve maxed out your 401(k) but haven’t opened an IRA yet and want to avoid paying taxes on brokerage account returns, an IRA is probably a better idea.
Tax-Efficient Strategies for Brokerage Accounts
While brokerage accounts are taxable, there are several strategies you can employ to minimize your tax liability:
1. Tax-Loss Harvesting: This strategy involves selling investments that have experienced a loss to offset any gains in your portfolio. By doing so, you can reduce your overall tax liability.
2. Asset Location: Placing investments with a high tax burden, such as bonds or actively managed funds, in tax-advantaged accounts like IRAs or 401(k)s can help to reduce your taxable income.
3. Holding Period: As mentioned earlier, the length of time you hold an investment can impact the tax rate. Consider holding investments for at least one year to take advantage of the lower long-term capital gains tax rate.
By implementing these tax-efficient strategies, you can make the most of your brokerage account while minimizing your tax liability.
Ending Note
While brokerage accounts are subject to taxation, understanding how they are taxed and employing tax-efficient strategies can help you maximize your investment returns. Remember to consult with a tax professional or financial advisor to ensure you’re making the most informed decisions regarding your brokerage account.
Ready to take the next step in your investment journey? Explore the possibilities of brokerage accounts and start building your wealth today!
