Lots of investing in funds, individual stocks and ETFs is done within some sort of retirement account for the tax advantage, but there are downsides to these investment vehicles.
Lots of investing in funds, individual stocks and ETFs is done within some sort of retirement vehicle (i.e. 401(k), 403(b), 457, IRA, Roth IRA, etc.) to gain some sort of tax advantage either on entrance or exit of the respective accounts. The downside of these investment vehicles that are earmarked for retirement is that there is a 10% tax penalty for withdrawal prior to age 59-and-a-half.
With banks generally offering rates less than typical inflation, many people want to find opportunity for upside potential without losing liquidity of their money. One opportunity to accomplish retaining liquidity but having more upside than currently offered rates is to participate in the market through mutual funds, ETFs and stocks in a non-qualified brokerage account.
There are many details to this, but one of the major parts of this portion of a financial strategy is the taxation of the gains and losses. You are not subject to any tax treatment upon the initial investment, but any earnings in these accounts on your investments are taxed at what is called capital gains.
Generally, there are two ways investment or capital gains can be taxed and they both depend on the length of time you are invested, as well as your federal income tax bracket. Investment gains are triggered to be taxed when you sell one of your holdings. If you buy and sell an investment in less than 12 months, you pay short-term capital gains, meaning the gain on the investment is simply added to your income and you are taxed at your marginal income tax bracket percentage.
Where you can potentially gain a tax advantage is when you hold an investment for more than 12 months. Depending on your marginal income tax bracket, you will be subject to long-term capital gains tax. If your federal income tax bracket is 10% or 15%, you are submitting to 0% capital gains. If your federal income tax bracket is 25%, 28%, 33% or 35% your long-term capital gains are taxed at 15%, and if you are in the 39.6%, then your long-term capital gains are hit at a 20% rate. In addition to the separation by these tax brackets for capital gains rates, there is also an additional 3.8% long-term capital gains tax, which kicks in for married couples making over $250,000 or folks who file single and make over $200,000.
In sum, once proper emergency reserves are established and you are saving a base amount for retirement, a happy medium between the two is to still make investments into the market with an eye for liquidity, which you may not currently have with your investments in a qualified account. In doing so, you will be able to create taxation diversification and may be better positioned come tax time. If this investment is held for over a year, you enter a separate method of taxation on your gains, which may be less than what your earned income is taxed at.
Jon C. Ylinen is a Financial Advisor with North Star Resource Group and offers securities and investment advisory services through CRI Securities, LLC. and Securian Financial Services, Inc., Members FINRA/SIPC. CRI Securities, LLC. is affiliated with Securian Financial Services, Inc. and North Star Resource Group. North Star Resource Group is not affiliated with Securian Financial Services, Inc.
Financial Advisors do not provide specific tax or legal advice. This information should not be considered as specific tax or legal advice. You should consult your tax or legal advisor regarding your own specific tax or legal situation. Please keep in mind that your state of residence may have tax restrictions as well. Investments will fluctuate and when redeemed may be worth more or less than when originally invested. 807287/ DOFU 01-2014.