Here Are All The Taxes In You’re Paying In Your Stock Portfolio
Many people don’t realize all the taxes involved in a stock portfolio without an efficient tax wrapper. By an efficient tax wrapper, I mean any tax-preferred vehicle like a retirement account, college savings fund, charitable fund, life insurance cash value, and others.
An investment portfolio can be comprised of individual stocks, individual bonds, treasuries, cash, money market accounts, certificates of deposit, exchange-traded funds, mutual funds, cryptocurrency and many others. Because equity investments (company ownership) are taxed differently than fixed income (debt instruments), the broad categories I’d like to focus on are equity-based mutual funds and stocks. Let’s explore the elements of these investment portfolios and how to optimize your tax strategies.
Capital Gains
When you sell a stock at a gain, that is known as a capital gain. This can occur intentionally on your part, by going in and selling a particular security. It can also happen without your explicit knowledge in the case of mutual funds. Mutual funds are diversified baskets of stocks with a specific objective. The fund objective is often something along the lines of maximizing income, long-term appreciation, or tracking a specific index.
For instance, you have a fund with an objective to track the S&P 500. The S&P 500 is the 500 largest publicly traded stocks in the United States, but the index is not constant. In fact, an average of about 20 changes are made to the S&P 500 each year, with more than a third of the stocks having turned over between 2014 and 2023. Every time there is a change to the index, your portfolio is selling and buying more stock, which could result in a capital gain even in years of negative investment performance.
The more actively you manage your portfolio, the more taxes will drag down your returns. There are two types of capital gains to be aware of.
Short-Term Capital Gains
If you buy a stock or fund and sell it within the same year, you will be subject to short-term capital gains. They are taxed like ordinary income, with the top federal tax rate at 37%. Please note that any time I mention federal rates, state taxes may also be applicable depending on your home state’s laws. While not always avoidable in funds, you might not have to pay this elevated rate by holding stocks for at least a year before selling.
Long-Term Capital Gains
Long-term capital gains are more tax-favored than short-term ones. They are the result of holding an asset for at least a year before selling. The top federal tax bracket for long-term capital gains is currently 20%, about half that of short-term capital gains.
Dividend Income
Many companies with publicly traded stocks will pay out dividends, which are a share of the profits or reserves that the company chooses to distribute to investors. Dividend income makes up an average of about 2% of the S&P 500’s annual growth, with many companies paying 1 to 2% and some paying over 4%.
So, if you hold a stock and never cash it out, there is a good chance that you are still paying taxes on dividend income. There are two types of dividend income: qualified and nonqualified.
Qualified Dividends
A stock dividend is qualified if it is a scheduled dividend paid from earnings or profits of a United States corporation or qualified foreign corporation, and it meets a holding period required by the IRS. The holding period terms are a little complicated, but most people can satisfy the terms by holding the stock for at least a few months. Qualified dividends are taxed at the same preferred rate as long-term capital gains, which is a top federal rate of 20%.
Nonqualified Dividends
Nonqualified dividends are any payments that do not meet the definition of qualified dividends. They are taxable as ordinary income at a maximum federal rate of 37%.
Medicare Contribution Surtax
The Medicare Contribution Surtax is designed to fund the Medicare system by only taxing people considered as high income. The tax threshold, created in 2012, included no adjustments for inflation. As a result, more people owe this tax each year. If you have Modified Adjusted Gross Income above $200,000 ($250,000 if married) and you have investments, you’ll likely be subjected to an additional 3.8% in taxes on your investment gains and income.
How To Optimize Your Portfolios
A potential way to minimize the impact of taxes on your portfolios is to invest within a tax-advantaged vehicle according to your goals. For example, if your goal is to save for retirement, consider maximizing a retirement account before investing in a standard investment account.
If you’ve maximized all your different tax-advantaged vehicles in accordance with your goals, we can minimize excess taxation in a standard investment account by:
Keeping rebalancing frequency down to once per year.
Investing in passive funds that have low turnover of stocks.
Selling some securities at losses to offset gains.
Sticking with your strategy over the long term.
There are many ways that taxes can eat into your investment returns. It is critical to understand the various taxes you pay in investment accounts and how to mitigate them to get the most out of your money. Consider working with qualified tax and financial professionals if you need support maximizing after-tax returns over time.
This informational and educational article does not offer or constitute, and should not be relied upon as, tax or financial advice. Your unique needs, goals and circumstances require the individualized attention of your own tax and financial professionals whose advice and services will prevail over any information provided in this article. Equitable Advisors, LLC and its associates and affiliates do not provide tax or legal advice or services. Equitable Advisors, LLC (Equitable Financial Advisors in MI and TN) and its affiliates do not endorse, approve or make any representations as to the accuracy, completeness or appropriateness of any part of any content linked to from this article.
Cicely Jones (CA Insurance Lic. #: 0K81625) offers securities through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC (Equitable Financial Advisors in MI & TN) and offers annuity and insurance products through Equitable Network, LLC, which conducts business in California as Equitable Network Insurance Agency of California, LLC). Financial Professionals may transact business and/or respond to inquiries only in state(s) in which they are properly qualified. Any compensation that Ms. Jones may receive for the publication of this article is earned separate from, and entirely outside of her capacities with, Equitable Advisors, LLC and Equitable Network, LLC (Equitable Network Insurance Agency of California, LLC). AGE-6194305.1 (1/24)(exp.1/26)
