This week on the Money Girl podcast, Finance Friday, we answer a great question from Elaine.
“I’m retired. Social Security Benefitspensions, savings, and Traditional IRA“I bought some real estate stocks about six years ago. The prices have gone up so I’m thinking about cashing them out. How much tax will I have to pay when I sell and how should I reinvest the money?”
Thank you so much, Elaine! I would love to see how much tax you have to pay on different investments and recommend some options to consider if you have extra money in retirement.
Types of investment taxes
Whenever you’re fortunate enough to earn money, whether from an employer, your own business, or investments, you usually have to pay tax. For 2024, your ordinary income is taxed according to seven brackets: 10% to 37%.
Examples of “regular” income include:
- wage
- Salary
- Tips
- Bonus
- commission
- rent
- royalty
- Short-term capital gains
- Non-qualified dividends
- Interest Income
However, certain types of investment income, such as long-term capital gains and qualified dividends, are taxed differently. Some taxes are only levied when you sell your investment for a profit, while others are levied when you receive dividends.
Another thing to consider is the type of account you hold your investments in. For example, a traditional tax-advantaged account like a 401(k) will only be taxed when you withdraw your money in retirement. Or Roth IRAAs long as you hold the account for at least five years, you can withdraw the money tax-free when you retire.
But capital assets, like a home, and investments in taxable accounts, like brokerages, owe tax when you earn money from them. The rate of tax you pay depends on factors we’ll explain below.
Related: 11 Best Brokerage Accounts
What is a capital gain?
The first type of investment income, capital gains, occurs when you sell an asset, such as stocks or a home, or sell it for more than you bought it for. Your profit minus your cost price is called your capital gain. For example, if you buy a share of stock for $20 and sell it for $30, you have a capital gain of $10.
Remember that capital gains are only taxable if you “realize” them by selling the asset. If you have an unrealized gain (also known as a paper gain), it’s not taxable. You can watch your asset grow in value and not have to pay capital gains taxes until you sell it.
Let’s say you made a profit of $10. You’ll have to pay capital gains tax on the entire amount. If you held the stock for a year before selling it, it’s a long-term gain and is currently taxed at the following reduced rates: 0% to 23.8%It depends on your total taxable income and tax filing status.
Keep in mind that some investments have higher capital gains tax rates: for example, collectibles such as rare coins and fine art typically have a long-term capital gains tax rate of 28%.
Elaine noted that because she held the stock for six years, she would be subject to long-term capital gains tax upon sale unless she held the stock in a retirement account. However, let’s assume for the moment that she holds the stock in a taxable brokerage. Her tax rate would depend on her tax filing status and total income.
For example, if Elaine is single and has a taxable income up to $47,025, she won’t incur capital gains tax on the sale of her stocks. If her taxable income is between $47,025 and $518,900, she will incur a 15% tax on her gains. Before deciding whether to sell or hold her stocks, Elaine may want to consult with a tax advisor to estimate her tax liability on the sale of her stocks.
If you hold an asset for less than a year, the capital gain is considered short-term and is subject to higher ordinary income tax rates, which can range from 10% to 37%. Therefore, holding an asset for a long period of time can help you minimize your taxes.
Also, if you incur a capital loss on your investment, you may be able to offset it against other gains or take a tax deduction, depending on your situation. However, you cannot claim the capital loss when you sell your home.
What is a capital gain from selling a home?
As I have shown, Selling a House Selling for profit also represents a capital gain for income tax purposes, but there is a special exemption for home sale gains of up to $250,000 for single taxpayers and $500,000 for joint taxpayers if you follow certain IRS rules: For example, the property must be your primary residence and you must have lived there for at least two of the past five years.
For example, if you buy a home for $300,000 and sell it 10 years later for $500,000, you’ll get a full $200,000 gain tax-free if you meet the ownership requirements. What taxes do I have to pay on the sale of my home?.
What are investment dividends?
The second type of investment income can come from owning dividend-paying stocks. Companies can either reinvest their profits back into the business or pay them out as dividends to shareholders.
While not all stocks pay dividends, many mature companies pay stable dividends that can grow over time. For example, Caterpillar Inc.Cat) pays a dividend yield of 1.57%. The dividend yield is calculated by dividing a stock’s annual dividend by its current price per share.
If you own dividend-paying stock, you automatically receive the dividend when the company declares it. You can take the dividend in cash or reinvest it in the company by buying more shares.
Either way, if you hold dividend stocks in a taxable brokerage account, you owe taxes. For example, if you receive $100 per month from dividend stocks, at the end of the year you’ll receive a statement from the company showing that you were paid $1,200 in income.
If you hold your investment for more than 60 days, your dividends are “eligible” for special tax treatment, meaning you’ll pay tax based on capital gains tax rates ranging from 0% to 23.8%, depending on your total taxable income.
As mentioned above, nonqualified dividends — dividends you hold for less than 60 days — are taxed at a higher rate than normal, and if you hold dividend-earning stocks in a retirement account, that income is sheltered from taxation temporarily in a traditional account and permanently in a Roth account.
reference: 10 rules to know for successful investing
What is interest income?
The third type of investment income is interest, which is earned from bank deposits, CDs, or bond investments and is generally taxed as ordinary income if held in a taxable brokerage or bank account.
There is an exception for interest on bonds issued by state and local governments that is exempt from federal income tax, and you may also qualify for state income tax breaks on certain investments, such as government bonds.
Speaking of states, be aware that your state of residence may impose its own taxes on investment income in addition to the federal tax rates I looked at, so if you have questions about your investment income, be sure to discuss your situation with a local tax advisor.
See also: Are you investing too much towards retirement?
How to invest your extra money after retirement
Elaine also asked what she would do with the cash if she sold her stocks. Depending on her financial situation, she could add the cash to savings, pay off debt, invest, or use it to reduce future taxes.
Assuming Elaine doesn’t have any high-interest debt, she might want to increase her savings balance, which is a safe choice. She’d be wise to keep at least a year’s worth of living expenses in an FDIC-insured high-yield savings account. If she already has enough savings, she could also buy CDs with higher interest rates.
But if Elaine is happy with her savings and retirement income, another option is to create a multi-year Roth conversion plan, a strategy that involves moving funds from traditional retirement accounts, paying income tax on withdrawals, and rolling them into an after-tax Roth IRA.
If you believe your tax rate today is lower than it will be in the future, it’s a smart move.
But it’s important to keep in mind that Roth conversions increase your taxable income and plan to stay in the lowest possible tax bracket each year. It’s wise to consult with a financial advisor to calculate your Roth conversion threshold.
Also, Elaine doesn’t say she has a Roth IRA, so she’ll need to open one. Her conversions are always tax-free, but she must hold the Roth IRA for at least five years before any earnings on the account will also be tax-free, regardless of age.
Depending on your tolerance for risk, you can invest the funds you convert to a Roth IRA in safe vehicles like CDs or money market accounts, or if you want more growth, you can invest in total market indexes or exchange-traded funds within your Roth IRA.
If Elaine is considering leaving assets to her heirs, making them the beneficiaries of a Roth IRA is a great way to pass money tax-free to future generations.
