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Taxes & Investment: What You Need to Know to Save Money

 The amount you pay (and when you pay it) is determined by the type of investment as well as a few other considerations.

Investing is a great way to develop wealth and security, but it's also a great way to rack up a large tax bill if you don't know how and when the IRS taxes investments.

Here are five main forms of investment taxes and what you may do to reduce your tax liability.

1. Capital gains tax

Capital gains are profits from the sale of an asset, such as shares, real estate, or a business, and they are usually taxable income.

How it works: Your capital gain is the profit you make on the sale of any of these items. For example, if you made a $10,000 profit on a stock this year, you may have to pay capital gains tax on the profit. The rate you pay is partly determined by how long you owned the asset before selling it. Capital gains are taxed at a rate of 0%, 15%, or 20% depending on how long the asset has been held. Capital gains taxes are equal to regular income tax rates on most assets held for less than a year.

How to decrease it: Capital gains taxes on assets can be reduced by utilizing losses to offset profits. Tax loss harvesting is the term for this. For example, if you made a $10,000 profit on one asset and lost $4,000 on another, you'll owe $6,000 in capital gains taxes.

Directly deposit your tax refund into an IRA account.

When you submit your taxes, you can instruct the IRS to deposit your tax refund directly into an IRA by completing IRS form 8888.

2. Dividend taxes

Dividends are typically taxable income in the year they are received. You must report a dividend even if you did not get it in cash — say, if it was automatically reinvested to buy more shares of the underlying company, as in a dividend reinvestment plan (DRIP).

How it works is as follows: Dividends are divided into two categories: nonqualified and qualified. Nonqualified dividends are taxed at the same rate as your ordinary income tax bracket. Qualified dividends are normally taxed at a reduced rate: 0 percent, 15%, or 20%, depending on your taxable income and filing status. Your broker or any company that issued you at least $10 in dividends and other distributions will send you a Form 1099-DIV or a Schedule K-1 after the end of the year. The 1099-DIV shows how much you were paid and whether or not the dividends were qualified.

How to reduce it: If you hold investments for a particular period of time, your dividends may be eligible for a lower tax rate. Remembering to save money aside for dividend taxes can help you avoid a liquidity crunch when the tax bill arrives, but keeping dividend-paying investments in a retirement account can help you avoid paying taxes on your investments.

3. Taxes on 401(k) contributions (k)

What it entails: In general, you don't pay taxes on money you put into a typical 401(k), and you don't pay taxes on investment gains, interest, or dividends while the money is in the account. Only when you remove money are you subjected to taxes. You pay the taxes up front with a Roth 401(k), but your eligible distributions in retirement are tax-free.

The money you remove from a typical 401(k) is taxed as regular income — like income from a job — in the year you take the distribution. If you take money out of a standard 401(k) before the age of 5912, you may be subject to a 10% penalty on top of the taxes (unless you qualify for one of the exceptions). If you wait too long to make withdrawals, you may be charged a penalty (after age 72). (Note: The age limit used to be 7012, and anyone who turned that age in 2019 is still subject to it.)

Learn more about the differences between traditional and Roth 401(k)s.

If you have to take money out of your account before you reach the age of 5912, investigate if you qualify for a penalty exemption. Tax-loss harvesting, borrowing instead of withdrawing from an account, and rolling over an account are all techniques to reduce taxes on investments.

4. Mutual fund taxes

What it is: Mutual fund taxes normally include dividends and capital gains taxes while the fund shares are owned, as well as capital gains taxes when the fund shares are sold.

How it works: The investments in your mutual fund may generate and distribute dividends, interest, or capital gains. As a result, even if you haven't sold any of the shares or received any cash from them, you may owe taxes on them. The tax rate you pay is determined on the sort of mutual fund distribution you get, as well as other criteria. You may be subject to capital gains tax if you sell your mutual fund shares for a profit.

How to minimize it : Waiting at least a year to sell your shares could lower your capital gains tax rate. Holding mutual fund shares inside a retirement account could defer the tax on the interest, dividends or gains your mutual fund distributes. Tax-loss harvesting and choosing funds less likely to distribute taxable income are other options.

5. Tax on the sale of a house

What it is: If you sell your home for a profit, some of the gain could be taxable.

How it works: The IRS typically allows you to exclude up to $250,000 of capital gains on your primary residence if you’re single and $500,000 if you’re married and filing jointly. Say you and your spouse bought a home 10 years ago for $200,000 and sold it today for $800,000. If you file your taxes jointly, $500,000 of that gain might not be subject to the capital gains tax (but $100,000 of the gain could be). What rate you pay on the other $100,000 would depend in part on your income and your tax-filing status.

How to minimize it: You have to meet certain criteria in order to qualify for this exclusion, so be sure to review them before you sell. You might qualify for an exception, and adding the value of home improvements you’ve made could help.

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