You’ve worked hard to build your nest egg. You’ve watched your investments evolve over time, and now you may be thinking about how to use those savings, whether for retirement spending, a major purchase, or simply improved financial security. Before you begin taking withdrawals, it’s important to understand how those distributions may affect your taxes.
Broadly, investment income is taxed in two primary ways: ordinary income tax rates and capital gains tax rates. Each applies differently depending on the type of investment you hold and how long you’ve held it. Having clarity around the tax landscape can help you make more informed decisions.
Ordinary Income
Many investments generate ordinary income, often through interest payments or certain types of dividends. This can come from familiar vehicles such as savings accounts, certificates of deposit (CDs), money market accounts, annuities, bonds, and some preferred stock. Understanding how this income is taxed can provide helpful context.
How ordinary income is taxed:
- In taxable accounts: Income is generally taxed in the year it is earned. In some cases, you may need to report more detailed information on Schedule B of IRS Form 1040.
- In tax-deferred accounts: Accounts such as 401(k)s and traditional IRAs allow investment income to accumulate without immediate taxation. Taxes are applied when funds are withdrawn, at which point distributions are typically treated as ordinary income.
Tax-exempt income: some investments, like municipal bonds or specific U.S. government securities, may generate income that is exempt from federal income tax and, in some cases, state income tax as well. The rules differ depending on the investment and where you live, so it can be helpful to look closely at how these apply to your situation.
Capital Gains
When you sell an investment, you may experience either a capital gain or a capital loss. Understanding how gains are calculated and taxed can give you a clearer picture of potential tax implications.
Understanding Basis
Your basis is the starting point for determining a gain or loss.
- Initial basis: Usually the original purchase price of the asset.
- Adjusted basis: This number may change over time due to events such as reinvested dividends, stock splits, or improvements made to real property. IRS Publication 551 outlines situations that can affect your basis.
The basic calculation is: Sale price – Adjusted basis = Capital gain (or loss)
Your holding period determines how gains are taxed:
- Short-term gains: For assets held one year or less, gains are taxed at your ordinary income tax rate.
- Long-term gains: For assets held more than one year, gains generally qualify for long-term capital gains tax rates, commonly 0%, 15%, or 20%, depending on your taxable income. Certain categories, such as collectibles, may be taxed at higher rates.
These gains and losses are reported on Schedule D of your federal return.
Using Losses Thoughtfully
Capital losses can sometimes help reduce taxes owed on gains. When losses exceed gains for the year, a portion may be used to offset ordinary income, with any unused losses carried forward. This can be a useful strategy depending on individual circumstances, though it’s important to review each situation carefully.
The Medicare Contribution Tax
Some higher-income taxpayers may also be subject to the 3.8% Medicare contribution tax on net investment income. This can apply to income such as:
- Interest and dividends
- Annuities, royalties, and rents
- Capital gains
- Certain passive business income
The tax is applied to the lesser of:
- Your net investment income, or
- The amount by which your modified adjusted gross income exceeds:
a. $200,000 for single filers
b. $250,000 for married couples filing jointly
c. $125,000 for married filing separately
It’s worth noting that distributions from qualified retirement plans and IRAs are not considered net investment income. However, they can increase your overall income and potentially cause other investment income to become subject to this additional tax.
Putting It All Together
Investment taxation can be layered and highly dependent on your personal circumstances. Understanding the basics helps you approach financial decisions with more clarity, whether you’re preparing to rebalance your portfolio, considering the sale of an asset, or planning for long-term withdrawals.
Working with both your financial advisor and a qualified tax professional can help ensure your strategy remains consistent with current tax laws and aligned with your broader financial goals. Your investments represent years of effort, and understanding how taxes fit into the picture can help you make the most of what you’ve built.
Ready to Talk About Your Tax-Aware Investment Strategy?
If you’re evaluating potential sales, planning distributions, or simply want a clearer view of how taxes may affect your investment decisions, GDS is here to help. Contact us to schedule a conversation about aligning your investment approach with a thoughtful, tax-aware strategy.
GDS Wealth Management is an SEC-registered investment adviser. Registration does not imply a certain level of skill or training. This material is for general informational purposes only and does not constitute individualized advice. Investing involves risk, including possible loss of principal. This material was created by Raymond James for use by its financial advisors. While we are familiar with the tax provisions discussed, we are not qualified to provide tax or legal advice. You should consult an appropriate professional regarding your specific situation. Tax laws may change at any time and could significantly affect your circumstances. Information has been obtained from sources considered reliable, but its accuracy or completeness cannot be guaranteed and it does not constitute a recommendation.
