Whether you earn income from working or from your savings or investments, the Internal Revenue Service is eager to claim the contents of your wallet. The IRS considers all income that is not specifically exempted from taxation by law to be taxable income. While it is unlikely that you can avoid income taxes altogether, you can at least manage the taxes on your investments based on the type of account you trade investments in.
The IRS considers most investments to be capital assets, which can appreciate or depreciate in value, but any change in market value does not result in a taxable event as long as you own the asset. Taxes are triggered only when you sell the investment. For example, you might have purchased XYZ stock at $20 per share, and over time its market price increased to $40 per share. Since you still own the stock, there has been no taxable event. If you decide to sell your stock, you'll owe taxes on the gain of $20 per share.
Long-term vs. Short-term
The amount of taxes you owe on an investment trade in your brokerage account depends on how long you've owned the asset. For assets you've owned for one year or less, the IRS considers the gain to be short-term, and it is taxed as ordinary income. If you owned the investment for longer than one year, your gain is taxed at the more favorable long-term capital gains tax rate. If you have loss on an investment trade, you can use that loss to offset some of your other investment gains.
Trades in an IRA
Investment trades inside your individual retirement account occur without creating a taxable event. Capital gains, dividend payments and interest income are all treated the same: They are not taxed as long as the money remains in your IRA. Distributions from your IRA might or might not be taxed as ordinary income, depending on whether you have a traditional or Roth IRA, and whether your distributions are qualified. Non-qualified distributions might also be subject to an additional tax penalty.
While the IRS puts few limits on the types of investments you can trade in your IRA, it does prohibit investments in collectibles such as gemstones and most precious metals. There are no such limitations with a traditional brokerage account. You're also limited in the amount you can contribute to an IRA each year. There are no limitations on the amount you can invest through a traditional brokerage account.
- CNN Money: Retirement: IRA Investment Advantages
- Forbes: Where to Open Your Brokerage Account
- Financial Industry Regulatory Authority: What to Expect When You Open a Brokerage Account
- Internal Revenue Service: Publication 590, Traditional IRA
- Internal Revenue Service: Publication 550, Sales and Trades of Investment Property
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.