Local, Money Matters

Investors’ Column… Taxes and other things

If you are like most people, you do your income taxes sometime about March, and send your tax returns off to the IRS by April 15th.

As you begin investing in stocks, it gets more complicated. And the IRS gets more demanding in what it requires you to do, as well.

A 401k account or a standard IRA account is in many ways simple to manage. Money placed into a 401k account or an IRA account is “pretax”; Uncle Sam does not take any income taxes out of it. You pay your taxes on it when you withdraw money from the account, after you retire. After you retire, you begin withdrawing a little ($30-40,000) each year. When you are retired it is expected that you will have a lower income, so you should pay less tax than when you deposited the money in your IRA. And since your current yearly income is slightly lower (by 6%, 10%, or up to 15%), you may pay less income tax right now, this year.

An alternative is to open a Roth IRA. The money you deposit in a Roth IRA is paid from your checking account; you have already paid income tax on it. While that money is in a Roth IRA account, you are free to buy stock with it, and make as big a profit as you are able – all of it tax-free. When you retire, you can withdraw that money just like with a standard IRA – but you owe no taxes on it.

With a standard IRA, you pay taxes when you withdraw from the account. With a Roth IRA, you deposit money which has already been taxed. Either way, while the money is in the account, you pay no taxes on any successful investments you make. There are advantages to both a standard IRA and a Roth IRA; learn the details from your broker or tax accountant before making a decision.

If you open an standard “after-tax” (non-IRA) account, you will need to keep a record of each stock purchase and sale you make, including the date of the purchase and the date of the sale.

When you sell stock, nobody computes the tax you owe, and nobody withholds any tax. But the IRS does not want to wait until April 15th to get that tax. Four times a year, you must estimate how much you made in that quarter, subtracting your losses from your gains, and pay an “estimated” income tax. If you were a successful investor, and made more than you lost, the IRS wants the tax it expects you to owe on that amount.

The estimated income tax has to be pretty close to the actual amount which will be on your yearly tax return, or the IRS will charge you a penalty fee that is not trivial.

If you have never bought a copy of TurboTax, it might be a good idea once you start investing. Buy the version that deals with investments and capital gains. Alternatively, consult a tax accountant, and follow his suggestions.
The key question about selling stocks is, “How long did you own the stock?” If that time is less than a year, then it is considered income, and is taxed at the same rate as your paycheck. But if you owned the stock for more than a year, your tax bill will be a bit lower; your profit is taxed at the “capital gains” rate. Tax-wise, it is to your advantage to own stock for more than a year.

Stock dividends

As mentioned in the January Investors’ Column, you not only make money by selling stock at a profit, but also whenever the company pays a stock dividend. You have two choices about what to do with that money: you can take it as cash, or use it to buy more stock, which is called “dividend reinvestment”. Dividend reinvestment is like compound interest: it lets you slowly increase the amount of stock you have, growing your investment at a faster rate.

Dividend reinvestment in an IRA or a 401k is definitely the best choice. That fits the whole purpose of a retirement account. In an after-tax account, it is still the best choice, but the IRS considers it income. So whether you take it as cash, or choose dividend reinvestment, the IRS will want you to pay the taxes on it – quarterly.

When you are just starting out, and the amount of stock you own is not very great, the tax on your dividend reinvestment will be small; you should be able to pay it out of your normal income. It is up to you to know whether your budget will allow you to choose dividend reinvestment.

One investment process is pretty much independent of tax issues: companies usually have some standard price-range per share of stock, which they feel best serves the interest of the company and its stockholders. If the company has grown (as we all hope they do), the stock price may increase well beyond that range. To bring the stock price back into that range, the company will announce a “stock split”. Typically, stock-splits are two-for-one: for every share of stock you own, you then will have two; twice as much. If you had 100 shares, after a stock-split you would then have 200 shares. The cost to you of owning those 200 shares is the same as when it was 100 shares, so the IRS does not count it as income.

The tax laws affect the choices made by every investor. There are many more details than can be covered in a small article. Talk with your broker about taxes and your personal situation. His knowledge on all investment issues is current and up-to-date; helping you is what he gets paid to do.

Whether you invest or not, you know that Congress frequently changes the tax laws, for better or for worse. For investors, staying aware of those changes can be crucial to lowering your taxes. Your broker and your tax accountant can keep you aware of any changes, and give you the best advice on what to do.

Scott Crosby

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