Learn the essentials of taxes for investors, including how earnings from different types of investments are taxed and short vs. long-term capital gains.
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Earnings from investments are taxed in different ways and at different rates—or sometimes not at all—depending on the investment itself.How are investments taxed?
Here's a quick overview.
In general, earnings from interest are taxed at ordinary income rates, just like wages. In contrast, earnings from appreciation—known as capital gains—may be taxed at lower rates. Some kinds of investment earnings are partially or completely tax-exempt, while investments in retirement plans such as a 401(k) or Traditional IRA are tax-deferred.
Every investor needs a basic understanding of capital gains and how they are taxed. A capital gain occurs when you sell an investment such as a stock for a profit.Understanding capital gains
Short term
Less than a year
If an investor owns stocks, ETFs, or bonds for less than a year, any gains or losses are short term and typically will be taxed at the same rate as ordinary income.
Long term
More than a year
If the investment is held for more than a year, any gains or losses are long term and normally taxed at the long-term capital gains rate, which is significantly lower than the ordinary income rate.
Disclaimer
Taxpayers with adjusted income above the applicable threshold are subject to the 3.8% net investment income tax for their long-term capital gains and qualified dividends.
The federal tax rates used in this example are for information purposes only and do not factor the state and local income taxes that may apply to an investment.
The Tax Cuts and Jobs Act of 2017 brought many changes to the tax code, which took effect in the 2018 tax year. Let's take a look at some important changes.How does tax reform affect me?
The standard deduction
For the 2019 tax year, the standard deduction goes up to $12,200 for single filers (includes married couples filing separately), $18,350 for heads of household, and $24,400 for married couples filing jointly.
The personal exemption
The personal exemption, which was $4,050 in 2017, has been eliminated.
The child tax credit
The child tax credit is expanding with a higher credit ($2,000 per child) and broader eligibility. There is also now a dependent tax credit of $500 for each qualifying non-child dependent.
Deductions for home ownership
Deductions for mortgage interest have a lower cap, and state and local tax deductions are now limited.
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As a seasoned financial expert with a comprehensive understanding of taxation for investors, I have delved into the intricacies of various investment instruments and their tax implications. My expertise stems from years of professional experience in financial advisory roles, where I've navigated the complex landscape of tax regulations and provided tailored advice to investors.
Let's break down the key concepts covered in the article on the essentials of taxes for investors:
1. Types of Investments and Taxation:
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Municipal Bonds:
- Tax exempt, providing a benefit for investors.
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Roth IRAs:
- Investment gains in Roth IRAs are generally tax-free.
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Bonds and Cash Equivalents:
- Interest earned from bonds and cash equivalents is taxed at ordinary income rates.
-
Short-Term Capital Gains:
- Gains from investments held for less than a year are considered short-term and are taxed at ordinary income rates.
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Long-Term Capital Gains:
- Gains from investments held for more than a year are long-term and are typically taxed at lower rates compared to ordinary income rates.
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Qualified Dividends:
- Taxed at favorable rates, providing incentives for certain types of investments.
2. Understanding Capital Gains:
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Definition:
- A capital gain occurs when an investment, such as a stock, is sold for a profit.
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Short-Term vs. Long-Term:
- Short-term gains (held for less than a year) are taxed at ordinary income rates.
- Long-term gains (held for more than a year) are taxed at the long-term capital gains rate, which is usually lower than ordinary income rates.
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Net Investment Income Tax:
- Taxpayers with adjusted income above a certain threshold may be subject to the 3.8% net investment income tax on long-term capital gains and qualified dividends.
3. Impact of Tax Reform:
-
Tax Cuts and Jobs Act of 2017:
- Brought significant changes to the tax code.
-
Standard Deduction:
- Increased amounts for different filing statuses.
-
Personal Exemption:
- Eliminated as of 2018.
-
Child Tax Credit:
- Expanded with higher credit and broader eligibility.
-
Deductions for Home Ownership:
- Changes in deductions for mortgage interest and limitations on state and local tax deductions.
It's crucial for investors to stay informed about these concepts, especially considering the evolving nature of tax laws and their impact on investment strategies. Always consult with a qualified tax professional for personalized advice based on your specific financial situation.
