Tax tips for new investors

You woman working in home office assessing the tax impact of her new investments. You woman working in home office assessing the tax impact of her new investments. Image:

In a Nutshell

Investing for the first time can be intimidating. Throw taxes into the mix, and you may think twice about starting at all. Yet investing can help you grow wealth and save for retirement. Tax on investments doesn’t have to be mystifying. These tips may help.

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Saving your money is a smart move, but is it the best way to make your money grow?

Many financial advisors encourage their clients to invest their money. Investing your money wisely can increase your net worth, but those gains come with tax consequences.

Savvy investors consider not just the potential returns of different investments, but how to take advantage of tax breaks that will help them keep more money in their pockets. If you’re ready to begin investing your money, here’s some information about tax on investments.


Beginning with tax-favored accounts

“Beginner investors should first think about investing in tax-favored accounts like a Roth IRA,” advises Lou Haverty, a chartered financial analyst with Financial Analyst Insider.

A Roth IRA is an example of a tax-favored account. You may also be familiar with traditional IRAs and 401(k)s. If you already have a 401(k) through work, or are saving for retirement in a traditional IRA, congratulations! You’re already a beginning investor.

Taking advantage of tax-favored accounts, such a traditional IRAs and 401(k)s, can allow you to invest without paying tax on that growth until money is withdrawn from the account. That’s generally when you’ll have to pay taxes on it. When you put money into a savings account, you likely will pay taxes on the interest it earns every year. But some tax-favored accounts can allow you to avoid paying annual taxes on investment income, letting you capitalize on compounded growth until you pull the money out in retirement.

So let’s take a look at some common tax-favored accounts and the benefits you’ll get from investing in them.

401(k) plan

If your employer offers a 401(k) retirement plan, that’s a great place to start investing. Contributions to a traditional 401(k) reduce your taxable income by drawing from your pre-tax income, so you could pay less federal income tax.

For 2018, you can contribute up to $18,500 to a 401(k) plan. If your employer offers any matching contributions, that’s additional money in your account.

Generally, you won’t pay taxes on investments in your 401(k) until you withdraw it as a distribution. Distributions are taxed, but the idea is that your tax rate likely will be lower in retirement than it is during your working life, so you’ll pay less tax on the money at that time.

Your employer may also offer a Roth 401(k) option. Contributions to a Roth 401(k) won’t reduce your taxable income in the year they’re made, but you won’t pay any additional tax on the contribution amount or on earnings when you withdraw money from the plan in retirement — meaning that your dividends and interest can truly grow tax free.

Beginner investors should first think about investing in tax-favored accounts like a Roth IRA.

Lou Haverty, Financial Analyst Insider

Traditional or Roth IRA

For 2018, you can contribute up to $5,500 to all your traditional and Roth IRAs ($6,500 if you’re age 50 or older) or your total taxable compensation for the year, whichever is less. That $5,500 is the total amount you’re allowed to contribute to all of your IRAs; having two IRAs doesn’t mean you can contribute $11,000.

Contributions to a traditional IRA may be tax deductible in the year they are made, but you’ll pay income taxes at your ordinary income tax rate when the money is withdrawn in retirement. Contributions to a Roth IRA are not tax-deductible, but qualified distributions are tax-free.

When choosing between a traditional or a Roth IRA, the decision generally comes down to whether you believe you’re better off paying taxes now or later. If you think you’ll be in a lower tax bracket in retirement, then taking advantage of the immediate tax breaks offered by traditional IRA contributions might make sense for you. If you believe your ordinary income tax bracket will be higher in retirement, then tax-free withdrawals from a Roth IRA could give you better tax advantages.

Additionally, you’ll have to take into account rules surrounding how much you can contribute to each type of account.

For Roth IRAs, there are income limitations. Single, head of household and married filing separately filers who make more than $135,000 can’t contribute anything at all, while those who make less than $120,000 can contribute up to the limit for their age. . The folks who fall in between are allowed to contribute a reduced amount.

Traditional IRAs have limitations on how much of your contribution you can deduct based on your income and whether you or your spouse is covered by a retirement plan at work. To learn more, visit the IRS page on contribution limits. Depending on your situation, you may be limited to one type of IRA.

Picking a retirement account

So which one to choose? If you have access to a 401(k) plan at work, contributing at least enough to take advantage of the full-employer match could score you some “free” money in the form of employer match contributions. You can also contribute more to your 401(k) until you reach the annual contribution limit. Or if you don’t like the fees or investment options offered by your employer’s plan, you can consider the tax-favored benefits of a traditional or Roth IRA next.

Alternatively, you can use choose to contribute to a 401(k) and an IRA at the same time. This would be an especially good option if you’ve managed to max out your contributions to your 401(k). The more you save and invest now, the more likely you’ll have a financially secure retirement later.

What is the Saver's Credit? Find out

‘Real investing’ and how it’s taxed

If you’re already taking full advantage of tax-advantaged retirement accounts, you may feel as if you’re ready to move up to “real” investing – the kind that can result in big payoffs (or losses) that are taxable.

You may be able to open an investment account at your bank, with an online brokerage or through a financial advisor. Within your account, you can invest in a variety of vehicles, the most common being stocks, bonds, mutual funds and exchange-traded funds (ETFs).

When you invest, you may earn income in the form of interest and dividends. That income is typically taxed at your ordinary income tax rate – the rate you pay on income from your job or business. But there are a few exceptions when it comes to tax on investments. Here are some of them (there are more):

Qualified dividends of stocks and stock mutual funds are eligible for a lower maximum rate on your federal return. In general, to qualify, the dividends must have been paid by a U.S. corporation or a qualified foreign corporation, and the stock must have been held for more than 60 days during the 121-period that begins 60 days before the ex-dividend date. The time limits differ for preferred stock.

All this sounds complex, but fortunately, you’ll receive Form 1099-DIV or Schedule K-1 from the payer at the end of the year that includes your ordinary and qualified dividends, so you don’t need to allocate them yourself.

Interest from municipal bonds is another exception. Government entities such as states, counties and cities issue municipal bonds to fund day-to-day obligations, build schools, highways and other public projects. Generally, interest income from these bonds is tax free on your federal return. Your state may offer income-tax benefits as well.

Capital gains and losses

When you sell an asset like stocks or bonds for a profit that exceeds whatever you paid for the asset, you have a capital gain. Generally, if you sell the asset one year or less after buying it, your capital gain or loss is short-term, and it’s long-term if you’ve held the asset for at least a year and a day.

How much tax you’ll pay on a capital gain is directly tied to your income and how long you’ve held the asset before selling it for a profit. Net short-term capital gains are taxed as ordinary income at graduated tax rates. Tax rates for net long-term capital gains can be lower.

When your long-term gains exceed long-term losses on an asset you sell, you have a net long-term capital gain. Your “net capital gain” is the amount your net long-term capital gain for the year exceeds your net short-term capital loss for the year. Most taxpayers pay 15% or less on net capital gains. However, if your taxable income puts you in the highest ordinary tax bracket (37% for 2018) you’ll pay 20% on net capital gains.

Learn more about the Net Investment Income Tax

For high-income earners, capital gains are also subject to a 3.8% net investment income tax. The NIIT affects taxpayers with modified adjusted gross income over $250,000 for a married couple filing jointly or $200,000 for single or head of household taxpayers.
If you have individual stocks and mutual funds that have realized big gains throughout the year, Haverty recommends considering a strategy called tax loss harvesting. The IRS allows investors to claim a deduction on capital losses. Capital losses are when you’ve sold something for less than you bought it. Tax loss harvesting means you sell investments that have lost money to offset some or all of the gains you realized during the year.

“The idea is that, if you have an investment that has a negative return, you sell the investment in December and your loss can be used to offset other income you have for that year, which reduces your (taxable income),” he says.

But don’t go overboard on loss harvesting, as there’s a limit to the capital losses you can claim on your return. If your capital losses are more than your capital gains, you can deduct only up to $3,000 per year ($1,500 if you are married and filing separately from your spouse). Any excess losses can be carried forward and taken in subsequent tax years, subject to the same $3,000 limitation each year.


Bottom line

Investing can be a way to build wealth and grow your nest egg for retirement. But you have to think about tax on your investments because any time you make money, there will be tax implications. Tax and investment advisors have a saying: “Don’t let the tax tail wag the investment dog.”

In other words, it’s never a good idea to make investment decisions based solely on tax considerations. That being said, it’s wise to consider the tax consequences of any investment moves you make. Taxes may not be the sole reason you put your money into one investment over another, but the tax breaks can be a bonus to an otherwise well-planned investment strategy.