You want to get started investing but you’re not sure how it’s going to impact your income taxes. What type of retirement account should you open? How will tax affect your personal investments?
These are smart questions to ask.
It’s important to do the right research so that you can lay out a solid investment strategy that works in conjunction with your needs.
Luckily for you there can be some serious tax benefits to becoming an investor. Let’s take a look at different types of investment accounts and how they can impact your taxes.
Taxes and Retirement Plans
Qualified retirement accounts, like 401k’s and Individual Retirement Accounts (IRA) let you invest pretax dollars. The money you sock away into these accounts will grow tax free and you’ll avoid paying tax on the money now. When you hit retirement age your withdrawals will then be taxed based upon the income tax bracket you fall into at the time.
By investing in these two types of accounts you’ll lower your current tax bill.
However, if you plan to be in a higher income tax bracket during withdrawal age then you might want to consider opening a Roth IRA.
A Roth IRA is a regular retirement account that allows you to invest money that has already been taxed. When you withdraw money during retirement you won’t have to pay income tax on your money.
If you’re not sure which retirement plan would best benefit you, a financial advisor can help you make the choice.
Taxes and Personal Investment Accounts
You’ll pay income tax on profits you receive when selling individual shares of stock in your personal investment account.
If you hold an investment for more than one year before selling for a profit, you’ll have a long term capital gain and will pay lower taxes than your regular income tax rate.
If you have a profit from selling shares that you’ve held for less than a year this is considered a short term capital gain. In this instance, you would pay your regular income tax rate.
If you invest in dividend stocks, you’ll also pay taxes on the dividend checks you receive.
In the event you incur a capital loss, you can use it to offset your capital gains and therefore lowering your tax bill.
So, Should You Consider Taxes When Investing?
You should absolutely consider taxes when investing. Investing comes with many tax benefits and can help you reach financial freedom faster. It is important though, that you take the time to choose the investment strategy that will benefit you long term.
Through qualified retirement accounts you can grow your nest egg tax free until withdrawal. And through a Roth IRA you can pay taxes now and avoid paying more taxes if you plan on being in a high income tax bracket during retirement.
Investing in your personal account is also a wise tax move. As long as you hold your shares for longer than one year you’ll pay less tax than you would on ordinary earned income.
This article was written by Robert Farrington from The College Investor, a personal finance site dedicated to helping millennials get out of student loan debt and start investing. Check out his free Ultimate Retirement Savings Guide for College Graduates if you want to learn how to get started investing.