It’s Tax Season! Do Taxes Affect Your Financial Portfolio?

How investments affect your taxes depends on the types of investments you have and what you did with them during the previous tax year. The funds and investments in normal brokerage accounts are treated differently than funds in pre-tax 401(k)s and after-tax Roth IRAs.

If you sell investments in your own personal brokerage account that isn’t specifically a retirement account, you might need to pay either short-term or long-term capital gains taxes. Whether your sale is taxed on the higher short-term rate or the (usually) lower long-term rate depends on how long you held the investment.

Investments sold after holding them for less than a year are charged the short-term capital gains tax, while investments sold after more than a year are taxed based on the long-term rate.

Short-term investments sold in a regular brokerage account are taxed like regular income at your tax rate (up to 37 percent for the highest income bracket). As of the 2021 tax year, the long-term capital gains tax rate is either zero percent, 15 percent or 20 percent, depending on your tax bracket.

The income level range for the 15 percent long-term capital gains rate is particularly wide. Any single person with an income between $40,401 and $445,850 should pay 15 percent on long-term capital gains (the profit from the sale of stock held for more than a year).

You can learn about the specific rates for your income and filing status from the IRS.

How Do Taxes Work for 401(k)s?

401(k)s are tax-deferred retirement plans. All the money that your employer invests into your 401(k) skips the normal income step of having a percentage withheld. When April rolls around, you aren’t expected to pay income tax on any money you’ve put into your 401(k) over the year.

The money’s growth over the ensuing years or decades is also tax free. You don’t have to pay any short-term or long-term capital gains taxes on any dividends or interest accrued in your 401(k).

Instead, 401(k) disbursements are taxed like regular income when the time comes to begin withdrawing funds. The rate at which you’re taxed on 401(k) withdrawals depends on your income tax bracket. Those funds will never be subject to a capital gains tax.  

Visit the IRS’ website to learn more about maximum contributions for your age.

Currently, 401(k) holders can begin withdrawing money penalty free once they turn 59½. The company managing a 401(k) generally withholds 20 percent from funds withdrawn early in order to maintain IRS compliance.

If you withdrew $1,000 from your 401(k) at 45, you’d likely only get $800. At tax time the IRS would also expect you to pay a 10 percent penalty for early withdrawal, so you’ll essentially only get $700 of the $1,000 you withdrew.

There are many scenarios in which the penalty is waived, but you’ll still be expected to pay taxes on withdrawals as if they’re normal income. Those special exceptions include things like:

• Needing to rebuild after a disaster hits your home
• Going through a divorce
• Transferring the money to an approved retirement account
• Needing to pay for qualifying medical expenses
• Having a child

Generally, early 401(k) withdrawals are best avoided. If you’re thinking about withdrawing money early to take a trip to Europe or pursue your dream of opening a coffee shop, art studio or some other small business, consider speaking with an investment advisor or personal tax planner first. They can explain your options and the potential repercussions so you can make an educated decision.

How Are IRA Withdrawals Taxed?

This depends on whether you have a regular IRA or a Roth IRA and when you start withdrawing funds. The 59½ rule applies to all qualified retirement savings plans, including IRAs. If you withdraw money before that age, you will need to pay the 10 percent penalty fee at tax time.

Roth IRAs are a partial exception. You must only pay the penalty for early Roth IRA withdrawals if you take earnings from the account.

Traditional IRAs are pre-tax dollars like a 401(k). Roth IRAs are post-tax dollars. When you withdraw money or take disbursements from a traditional IRA, you’ll need to pay taxes on it as income. You generally don’t have to pay income taxes on withdrawals from a Roth IRA.

One of the benefits of a traditional IRA are tax deductible contributions. You don’t have the option to deduct Roth IRA contributions from your yearly taxes. The tax-free Roth IRA withdrawals also only go into effect if you’ve had the account for at least five years.

Want to Understand How You Can Maximize Tax Savings With Your Retirement Investments?

At Fullerton Financial Planning, we are committed to helping our clients develop tax-efficient retirement investment strategies. We’ve even incorporated estate planning professionals into our team to ensure our clients have all their retirement planning bases covered.

If you’d like to learn about the most effective way to grow your retirement savings while minimizing your tax exposure and safeguarding your legacy, request a consultation with our team. Call us at (623) 974-0300 to schedule a meeting with a financial advisor.