Tax Consequences of Investing

The tax code is complex and constantly changing, but the tax consequences of building and maintaining a diversified investment portfolio are fairly straightforward. I will provide an overview of taxes and investments in this post and then delve into more details regarding specific investments at another time.

The federal tax system classifies taxable income in two ways. Income is considered ordinary income or capital gain income. The capital gain classification is then broken down into short-term or long-term capital gains. Ordinary income is taxed on a sliding scale in a progressive manner. This means that the higher your income, the higher percentage you typically pay in tax. Short-term capital gain income is taxed at your ordinary income tax rate. Long-term capital gain income is typically taxed at a flat 15% income tax rate.

Investment assets (stocks, bonds, mutual funds, CDs, etc.) are taxed in two ways. The first is the income that these assets produce on an ongoing basis. This income is taxed as ordinary income, except when it is qualified income and it is taxed at a 15% rate. The gain or loss realized from selling these investments, after holding them for a short-term (one year or less) period or long-term (greater than one year) period, is taxed at the capital gain tax rate described above.

As this basic introduction to investment taxability illustrates, the tax code is complex and convoluted. Despite being a Certified Public Accountant (CPA), I wish that Congress would enact a simple, straightforward tax system, as opposed to playing political games with our money. In the meantime, we are required to spend a lot of time learning how our tax system works or having professionals do this work for us.