How Are Taxes Calculated on a Brokerage Account if I Withdraw?
Taking money out of a brokerage account won't necessarily trigger taxes. Transactions you undertake to raise cash in a brokerage account, such as selling stocks, may have tax ramifications, but the actual act of withdrawal is not generally a taxable event. If you have a brokerage retirement account, however, you may face both taxes and penalties if you make a withdrawal. No investment decision should be based solely on the tax implications, but you should understand how brokerage accounts work before you do trigger any extra fees or taxes.
Brokerage Account Definition
A brokerage account is a special type of holding place for investable funds. Structurally, a brokerage account is somewhat like a checking or savings account, in that you can generally make contributions or withdrawals at any time. However, a brokerage account gives you a broader range of investment options. In a brokerage account, you can typically buy nearly any type of security, from stocks and bonds to mutual funds, exchange-traded funds, Certificates of Deposit (CDs) and even commodities like gold. Depending on the brokerage firm where you open your account, you may have access to proprietary products, such as in-house mutual funds, that you might not be able to buy from other firms.
Brokerage Account Taxation
Just like a checking or savings account, there are no tax consequences to moving money into or out of a regular, taxable brokerage account. However, there are numerous transactions that can occur within a brokerage account that can result in taxation. The most obvious is if you sell a security, whether it's a stock, bond, mutual fund, exchange-traded fund or any other capital asset. These types of assets generate capital gains (or losses) depending on the difference between the amount you paid and the amount you received after a sale.
Even if you don't sell any of your stocks or bonds, you can have taxable events in your brokerage account. When stocks pay dividends, that payout is taxable, even if you automatically reinvest the dividend into additional shares of stock. The same is true of bond interest, or the dividends you get on a money market or savings account. All of these types of income are taxable in the year in which you receive them, whether or not you take the money out of your account.
Calculation of Tax Liability
Calculation of your tax liability in a brokerage account can be complicated. In many instances, you may want to consider working with a financial adviser and/or a tax accountant. However, every investor should be aware of the basics of brokerage account taxation.
For income investments, such as bonds, interest is taxable as ordinary income. This means that you'll pay your marginal tax rate on any income generated in the account. For example, if you earn $10,000 in bond interest and you are in the 24 percent tax bracket, you'll owe $2,400 in income tax on that interest.
Qualified Dividends Tax
Cash dividends paid by stocks and mutual funds are also usually taxable as ordinary income. One exception is if your dividends are "qualified." Qualified dividends are essentially regular dividends from companies you have owned for a period of time. The rules can get complex, but holding a stock for at least 61 days can often be sufficient. The benefit of a qualified dividend is that it is taxed at capital gains rates, rather than ordinary income rates.
Capital Gains Tax
Capital gains tax rates, as the name implies, apply not just to qualified dividends but also to capital gains, which are profits generated from the buying and selling of capital assets, such as stocks, mutual funds, or ETFs. Capital gains tax rates are beneficial because they are usually lower than ordinary income rates. For example, in tax year 2018, tax brackets ranged from 10 percent to 37 percent. According to the IRS, however, long-term capital gains rates for most taxpayers are either zero percent or 15 percent, with the top rate being 20 percent.
An important factor in properly calculating capital gains tax is determining your holding period. For assets held one year or less, capital gains are considered short-term, while those held for more than one year are considered long term. This distinction is important because only long-term capital gains benefit from the reduced tax rate. Short-term capital gains are taxed at ordinary income rates. In other words, if you're in the 24 percent tax bracket, a $10,000 short-term capital gain would trigger $2,400 in capital gains tax, whereas a $10,000 long-term capital gain would only generate $1,500 in tax.
Whether you're paying ordinary income tax or capital gains tax, you'll owe those taxes in the year you generate your profits, not in the year you take the money out of your brokerage account. Leaving the money in your brokerage account or withdrawing it has no bearing on when or how much tax you will owe.
Brokerage Account Vs. IRA
An Individual Retirement Arrangement, also called an Individual Retirement Account or IRA, is a special, tax-advantaged account that can also be opened as a brokerage account. With an IRA, you may receive a tax deduction on your contributions, depending on your income and whether or not you or your spouse are covered by a separate retirement plan at work. The IRS limits contributions to an IRA to $5,500 for tax year 2018 ($6,000 for tax year 2019), with an additional $1,000 "catch-up" contribution for those age 50 and older.
In addition to possible tax-deductible contributions, earnings within an IRA brokerage account are tax-deferred. For example, if you earn $10,000 in dividends, interest or capital gains in an IRA one year, you won't have to report that income on your annual tax return. However, most distributions from an IRA are fully taxable as ordinary income.
This can make IRAs a bit of a double-edged sword when it comes to taxation. Yes, deductible contributions and tax-deferred growth are obviously greatly beneficial. But the downside is that you won't benefit from lower tax rates on any long-term capital gains you may generate in your IRA, as all distributions are taxable as ordinary income.
For example, imagine that your entire IRA is invested in stocks, and you hold those stocks for 20 years, finally selling and generating a $100,000 gain. If that money was in a taxable brokerage account, you'd owe 15 percent in capital gains tax, or $15,000. However, when you take that money out of an IRA, you'll pay your full ordinary income tax rate on the balance, even though it was a long-term capital gain. If you're in the top tax rate for 2018, which is 37 percent, you'll owe $37,000 in taxes on that distributed balance.
The Bottom Line
When you invest money in a brokerage account, tax liability is an ongoing process. Whether you buy and sell capital assets like stocks or simply sit back and collect dividends and interest, you'll have to report that income to the IRS every year and pay tax, unless your brokerage account is in an IRA. Keeping your profits in a regular, taxable brokerage account does nothing to shield you from your tax liability, just like withdrawing funds from a regular, taxable brokerage account doesn't trigger a tax liability.
John Csiszar has written thousands of articles on financial services based on his extensive experience in the industry. Csiszar earned a Certified Financial Planner designation and served for 18 years as an investment counselor before becoming a writing and editing contractor for various private clients. In addition to his online work, he has published five educational books for young adults.