Investment Taxes…What You Need to Know

Are you ready to understand the ins and outs of investment taxes? It's not just about paying up, it's about keeping more in your pocket!

In today’s episode, I break down the complexities of investment taxes and how they impact your financial future. I discuss the different types of investment income, how they are taxed, and strategies to minimize your tax liability. From dividends to capital gains, I walk you through it all, so you can harness the power of the tax code to build your money machine.

Want to take control of your financial future and keep more of your hard-earned money? Tune in to the full episode now!

IN TODAY’S EPISODE, I DISCUSS: 

• Taxation of dividends, including qualified and non-qualified dividends
• The taxation of interest income and its exceptions in federal and municipal bonds
• Understanding capital gains and the influences of short-term and long-term investments

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If you liked this episode, you'll love these ones:

• Mutual Funds, Index Funds or ETFs, Which is Best?
• How to Actually Make Money Investing
• Q&A - Should I Invest in a Roth or Traditional IRA
• Why HSA Accounts Are So Powerful

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Transcript

1:56

You know what they say, two things you can't avoid is death and taxes. Well, we're going to talk about taxes in this episode, in this video, and we're going to talk specifically about investment taxes, because when you understand them, you may not be able to avoid them, but we will be able to minimize them. And because you're making money through investments, it's taxed very differently. We have a different kind of tax structure for investments. And I want to walk you through each and every type of investment income, how it's taxed, what you need to be watching out for, and how to make sure that you keep more of the money in your pocket working for you. Because after all, that's what it's meant to do, not there to work for the government. It's there to give you the life that you deserve. So enjoy this episode of the affluent entrepreneur show, and I'll see you in the episode. This is the affluent entrepreneur show for entrepreneurs that want to operate at a high level and achieve financial liberation. I'm your host, Mel Abraham, and I'll be sharing with you what it takes to create success beyond wealth so you can have a richer, more fulfilling lifestyle. In this show, you'll learn how business and money intersect, so you can scale your business, scale your money, and scale your life while creating a deeper impact and living with complete freedom, because that's what it really means to be an athlete entrepreneur. All right, taxes. This is a fun thing to start the year off with, isn't it? But it's a necessity. Here's my thinking behind this. If taxes can cost you 30% to 50% of the income that you're making, then it's really important for us to understand some of it so we can keep the majority of it, that we can use the tax code to our advantage and not theirs. Because, yes, we might have to pay taxes, but we're not responsible for overpaying our taxes, so we might as well use it for the way that it was meant to be used. And so in this episode, I really want to dig into investment taxes, primarily what happens when you're getting dividends, interest, capital gains. How is it taxed? What are the different rates? And what do you need to think about? So this is important. Don't tune me out on this one, because can you imagine you make a whole lot of money in the stock market or on investment, and they turn around and say, hey, give us our pound of flesh. And they want to take part of the bone with it because they ask for 40% and you go, oh, I spent it. Well, we're not going to let that happen. Let's do this the right way. First things first. I want us to understand something, because I hear this all the time about the tax system. Now, mind you, this is primarily in the US. Actually, it's in the US. We have something called a progressive tax system. And this is the thing that a lot of people will say, when I had my CPA firm and they would come to me and say, I can't earn any more, go, I mean, income. And I go, why can't you earn any more income? Because I'll be in a higher tax bracket. The answer to that is probably yes. But here's how this thing plays out. When you do something like this, is that ultimately, and I'm going to go to my iPad, so we just kind of pencil this out. Let's assume that because it's a progressive tax structure, let's assume I'm going to make the numbers easy for me. I have$100,000 in income and that's taxed at, let's say, 15%. That means that you're going to pay $15,000 in taxes. Okay? But let's say that anything that once you go above $100,000, that 15% goes to 20%. So what happens is this. Let's say that you make an additional$50,000. Okay? So instead of 100,000, let me do it in a different color. Instead of 100,000, you make 150,000. So you make 150,000. Because we're in a progressive tax system, here's what's going to happen. The 100,000 is still going to be taxed at 15%. Then the 50,000 that is over and above that, because that's in the new tax bracket is taxed at 20%. So that's another $10,000 in taxes. So your total tax is$25,000 under this structure, where 100,000 is the limit for the 15% bracket and then 20,000. The mistake that a lot of people make is they think that the full$150,000 is going to be taxed at the 20% bracket. And that's not really the case. That's not the way it works. It's a progressive system. So the next dollar gets taxed at the higher rates. So in the end, you're still making more money. Make as much income as you possibly can, and know that even if you're in a higher tax bracket, you're still making more money. Get that earnings shovel as big as possible, because when that earnings shovel is big, you have a lot more cash flow going towards building your money machine, creating financial freedom, getting you out of debt, doing the things that you want to do. So don't get confused with the idea that if you move from one tax bracket to the next that all your income is going to be taxed at that higher rate. It's not. It's just the incremental income above the threshold that will be hired. It's a progressive tax system. So that's the first thing that I think we need to be really aware of as we're doing this, because too often we're confused and we think, well, maybe I better not make more money because I'll be in another tax bracket. Okay, now there are some strategies to use the tax brackets beyond this. I want to talk strictly about investment taxes here, but I think it's important for us to just kind of put that on the table that we're in a progressive tax system. All right. Now I want to talk about the fundamentals first. There are a couple of different ways your investments might be taxed, and I'm going to do that by going to some slides so you understand how this plays out at the base and the way the tax code is written. Everything you receive, everything in cash, check, charge, barter. Okay, cash, check, charge, a barter. Everything you receive is taxable. And anything else has to have an exception in the tax code. So if you look at the general rule of the tax system, it says 100% of everything you get is taxable, no matter what the source is. Then the rest of the tax code, all the volumes, is to tell you the exceptions. So what's going to happen is that everything you receive is going to be taxable at what we call the ordinary tax rate. This is going to be the highest rate possible, depending on the bracket you're in. And it can go up to 30 plus percent. And then you add state on that, like my beautiful state of California, you could be over 50%. All right. So when you earn something, it is automatically part of the ordinary tax rate unless there's a specific exclusion for it or an exception. And that's what happens with a lot of investments, is that they get special treatment because they want to use, what they're trying to do is incentivize people to invest, to make capital investments, to do some of the things. They use the tax code, like it or not, right or wrong, they use the tax code to kind of accelerate or accentuate different elements of the economy and behaviors of the taxpayers. And so you have this ordinary tax rate, which is typically going to be the highest rates you're going to pay. Then from there, one above that, that is what we call long term capital gains. This is where you can actually pay tax under the current law, you can pay tax under one of three rates, 0%, 15% or 20%, depending on your income. But in order, there's some nuances there. We'll talk about those nuances and where the breakpoints are, but that is where a lot of what you want to do with your investments, you want it to land, because that's going to be probably the lowest tax rates you're going to get to try and minimize it. And there's some things to do to make that happen. Then beyond that, there are some things that are non taxable that you don't ever have to pay tax on. So they excluded them. We'll talk a little bit about some of those types of things in this. So I just wanted you to start, to start with this foundation. Ordinary tax rates, the highest rate, long term capital gains, probably one of the lowest rates. And then there are some things that you don't have to pay tax on, and it basically has to be in the code, otherwise you got to pay tax on it. So let's break this down. And the way I'm going to break this down for you is going to break it down based on the kind of income that you're making from your investments. Okay? So the first one that I want to do is I really want to just touch on dividends first. Okay. Dividends are money that are paid out to you based on owning an interest in a company. So you own a stock, that company, sometimes many companies, what they'll do is they'll take a portion of their profits and they'll give it back to the shareholders. And they do that as a dividend. And so what happens is those dividends that come out to you are taxable when you look at it from that perspective. They can be treated one of different way. Two different ways is your dividends can either be what they call qualified or non qualified. A qualified dividend is one that qualifies for capital gains treatment. In other words, you get the advantage rates of 0%, 15% or 20%. Just so you understand how that plays out. Let me just move to here real quickly. So you see, it is that the capital gains rate currently, and these can change. These can change. But when you look at it, you have 0%, 15% or 20%. Now, mind you, the ordinary income tax rate, better put that in red. The ordinary income tax rate is 30 plus percent, depending on where you're at. So if you can get things classified as long term capital gains, we'll talk about what that is, or qualified dividends. You get these advantage rates, but the only way you get these is it depends on your income at the 0% rate. If you're single right now, your income has to be less than 47,000, approximately. Okay, 47 and change. If you're married filing joint, it's basically top twice that. So it's about 94,000. So if you had no other income except for qualified dividends and you were married, you could get $90,000 in dividends and not pay tax on it because it's at the 0% rate. The 15% rate goes beyond 47. So if you're single, it's above forty seven thousand k, up to five hundred and eighteen thousand for a single. For married, though, it's interesting. It goes from ninety four k up to five hundred and eighty four thousand. So it seems like they're penalizing someone for being married. They didn't exactly double it. Okay. And then anything above the 518, if you're single, or the 584 in your income is going to get taxed at 20%. So it's important to understand that if you have qualified dividends, you want as much in qualified dividends as you possibly can have because it's going to give you the lowest rate. But your lowest rate could be as high as 20%, depending on the rest of your income. Okay, so this is why, when you look at this, non qualified dividends don't qualify for capital gains treatment. It will be taxed at your normal rates, the ordinary rates, which is going to be whatever your rate is. But qualified dividends will get taxed at the capital gains rates, depending on your income as it goes. So that's the first form of investment income that you might have is dividends. Now, one other nuance to think about, there are things that they call drip dividend reinvestment plans. Okay, so what happens, and these happen a lot in mutual funds and things like that. So what ends up happening is that when you get a dividend, you're automatically reinvesting it. So the money is churning and you keep building and building units in the fund that you're in. Here's the thing, though, that even though you never received the cash, so let's say that they pay you $100 dividend and you reinvest and it automatically reinvests to buy more units. You never receive the $100, but in the IRS's eyes, in the government's eyes, any dividends received through a drip program that get reinvested are still income. So you actually have to pay tax on it. And you didn't receive the cash. So you want to be aware of that. Doesn't mean you don't go into these drip programs. I'm into them a lot because they grow. You just need to have the liquidity to pay the taxes on what's coming out and getting reinvested in there. So just know that if you're in a drip program, it doesn't mean that it's completely tax free. All right? Just because you didn't receive the money doesn't mean it doesn't count. All right, so that leads me to this second category of income. And the second category of income is what we call interest income. Okay? It's interest income. Now, this can be from cds, it can be from municipals, it can be from federal bonds, it can be from you doing personal loans. It can be just from a lot of things. Now, the majority of the time, the interest income, the stuff you get in savings account, your high yield savings account, is going to get taxed at your ordinary tax rate. At the highest tax rate. There are a few exceptions. They're nuanced, so you need to be aware of it. So if I get interest, if I'm invested in federal types of investments, treasury bills and things like, and bonds, many times you still have to pay federal tax on it at your tax rate, at the ordinary rate. But there are state tax exempt, so you can avoid the state taxes on it. Okay, now flip that. If you buy into municipal bonds that are from your state and local governments, many of those you have to pay state tax on the interest you receive, but they're federal tax exempt. So from an interest standpoint, most of the time it's going to be taxable at your ordinary tax rate. But if you have federal or state, you might have the ability to avoid one or the other as far as taxes go. All right, that leads me to this. This is the next piece. This is the big thing is really capital gains. What are capital gains? Capital gains are when you buy an asset and that asset goes up and you sell it and you have a gain. I buy a stock at $100, it goes to $150. I sell it at 150. I now have a $50 gain. You have to pay tax on it. Now, remember I said there's long term capital gains rates that are 0%, 15% and 20% currently. The thing is that in order to qualify for those rates, you must have held the asset for more than a year. Shame. For more than a year. Okay. If you do not hold it for more than a year, then you don't get those rates. You have to pay at the ordinary rate. So someone that is buying and selling stocks within a year isn't going to get any kind of advantage. They're going to pay it at their maximum rate. I trade stocks. I do options. Most of that stuff is ordinary income. I know that I'm paying at the highest rate. And as long as I'm making the money, I'm okay with it because I'm willing to know that I'm still netting better. Okay. Now, my long term investing is long term. It's held for well over a year and I don't have to worry about it. So we need to be mindful of the fact that there's short term gains. Short term gains are less than a year. Those will always be taxed at your ordinary rates. There's long term gains. Those are those things that you hold for more than a year. Those will be taxed at the long term capital gains rate, depending on your income, based on those thresholds that I gave you for the moment, then you might get what's called capital gain distributions or distributions from, like, mutual funds and things like that. That depends. Then they will classify it with a short term or long term. So it just depends. It depends on how they come about. Now, there is something else to think about here is that I'm talking about gains get taxed. Well, what happens about losses? What do you do if you lost money on investments? Let's not make a habit of that. We don't want to lose money on investments as a habit. That happens, I lose money. So the way this works is you can use the losses to offset the gains and you can use $3,000 over the gains to offset other income. So let me throw some numbers at you, and I'm doing this. Generally, there's some nuances in the way you calculate it that I'm not going to get into here, because I'm not trying to make you accountants. I'm just trying to get you to understand the fundamentals and the foundation. Let's assume that you bought a stock for$10,000, some stock, you sold it for 15, you end up with a$5,000 gain. Then you bought another stock for$12,000, and you sold it for $1,000. It tanked. So you have an $11,000 loss and a $5,000 gain. So they would offset each other. So the $5,000 gain you wouldn't pay tax on because you have an $11,000 loss. But what do you do about the rest of the 6000? Because if we just do the math, if I just go here to do the math and you go, okay. So I had 10,000 and I sold it for 15,000. That gave me a$5,000 gain. Then I ended up buying another one for 12,000, sold it for 1000. I end up with an$11,000 loss. Loss. So now I end up with this $6,000 loss that's just sitting here. What do I do with that? Well, the tax law says we will let you take $3,000 of that a year until it's used up indefinitely so you don't lose it. You can take $3,000 against your income now and then the other 3000 will have to come next year or against some other gains next year. But my point is that you don't get to take all the losses over and above the gains. You could only take up to $3,000 over and above the gains. So just know that there's some limitations on the losses, but they're going to get you on the gains every single time. So what we try to do is if you have some things that are gains, when I have a bunch of gains that I made that I know that are there and I see some things that are losses, we will sell the things at losses to offset the gains. So we don't have a bunch of stuff that I can't take a deduction for. Okay. All right. So let's go to the next, that is capital gains. Let's go to the next type of income, and that is mutual funds. We talked about this in another episode or video. Your mutual funds are going to be managing their portfolio. So they're going to be constantly buying and selling and doing things in the portfolio. And depending on the rules still apply to them now. So depending on how they held it, if they bought and sold a stock less than a year, it's going to be a short term gain. It will be coming out to you. You will pay tax on that as ordinary income. If they held it more than a year, it'll be long term gain. When the mutual fund gives you their tax form at the end of the year, they will do the calculation for you. You don't have to worry about it. They're going to tell you this amount was long term, this amount was short term. Okay? And then there may be some capital gain distributions, and they will tell you again as to whether those are going to be short term or long term, to tell you which tax rates you're going to apply to it. And that leads me to this last category that I wanted to put in here, and that's your retirement accounts. Two primary style of retirement accounts, I'm going to say Roth and traditional. Anything that goes on inside the retirement account. Anything that goes on inside any of the retirement accounts while it's inside the retirement account, there is no tax on the gains, the losses, all that. There's nothing. It just does it inside there and nothing happens. Where they get you is when you withdraw it out. And you have two types of accounts, Roth and traditional. And these traditional could be your 401K, could be an IRA, could be a sep, it could be a cash balance plan. If it's not a Roth element, the Roth is 100% tax free. Okay? So no matter what happened in the Roth, it's 100% tax free. And the reason for it is that when you put money in the Roth, you get no tax deduction for it. I did a whole nother episode on Roth IRa versus regular IRA. You can check it out or another video on that. You don't get a tax deduction when you set it up and you put money in it. Every time you put money in it, you don't get a tax deduction. So you're paying taxes upfront on it. That means that no matter how high it grows, no matter how large it grows, when you take money out after you're qualified, 59 and a half and beyond. Okay. When you take money out, it's 100% tax free on all the gains, all the things. That's why Roth is such a powerful mechanism, if you can apply to you, because there's income limitations and there's some limitations with it, but the fact is that it's completely tax free when it comes out versus the traditional retirement accounts. What happens is that no matter what happened during the time that you had the account, while you were working, putting money in gains and losses, no matter what happened, when you draw money out after age 59 and a half, currently it's 100% taxable at ordinary tax rates. It is at whatever your tax rate is at that time. And the reason for that is you're taking a tax deduction when you set it up. And every time you contribute to it, they said, you got the benefit early on. So we didn't get our taxes. We're taking our taxes on the back end. So that's the two different ones. These are the primary ways and income streams from your investments, and this is the way that they get taxed. Bottom line is this, we're not going to avoid taxes, but there are ways to use the tax code properly, effectively and legally to minimize your taxes. And the only way you can do that is by having, at least as an investor, a fundamental understanding so you can have a real conversation with your tax strategist, your tax planner, your tax preparer and all of that to make it happen. As you grow, as you go, as you start to build your money machine, this becomes a really important thing, because a million dollars in a traditional IRA is not the same as a million dollars in a Roth IRA. A million dollar gain, that is a long term capital gain, is not the same as a million dollars in a short term capital gain or interest or non qualified dividends. It's important to understand. That's why I did this video, why I did this episode. Hopefully this gives you a perspective. It's not meant to make you a tax expert. Lord knows I didn't go into any of the nuances and stuff like that. But it is meant to at least raise your awareness, give you some direction, give you some understanding, and give you a pathway to help you keep more money in your pocket so you can build your money machine much faster. On the road to financial freedom. It's financial freedom, after all. It's your birthright. Let's go claim it. All right, until we get a chance to see each other, another episode, another video, on a podcast or on the road. Always, always us. Strive live a life that lives you. Thank you for listening to the affluent entrepreneur show. With me, your host, Mel Abraham. If you want to achieve financial liberation to create an affluent lifestyle, join me in the affluent entrepreneur facebook group now by going to melabraham.com/group, and I'll see you there.