How are taxes calculated on a brokerage account if I withdraw? | Finance
Withdrawing money from a brokerage account will not necessarily trigger taxes. Transactions you undertake to raise funds in a brokerage account, such as selling stocks, may have tax ramifications, but the actual act of withdrawal is generally not a taxable event. If you have a brokerage retirement account, however, you may face both taxes and penalties if you make a withdrawal. No investment decision should be based on tax implications alone, but you should understand how brokerage accounts work before triggering additional fees or taxes.
Brokerage account definition
A brokerage account is a special type of holding place for investable funds. Structurally, a brokerage account is a bit like a checking or savings account, in that you can generally make contributions or withdrawals at any time. However, a brokerage account gives you a wider range of investment options. In a brokerage account, you can typically buy almost any type of security, from stocks and bonds to mutual funds, exchange-traded funds, certificates of deposit (CDs), and even commodities like gold. Depending on the brokerage company you open your account with, you may have access to proprietary products, such as in-house mutual funds, that you may not be able to purchase from other companies.
Taxation of the brokerage account
Just like a checking or savings account, there are no tax consequences to transferring money to or from a regular, taxable brokerage account. However, many transactions can take place in a brokerage account and may result in taxation. The most obvious is if you’re selling a security, whether it’s a stock, bond, mutual fund, exchange-traded fund, or other fixed asset. These types of assets generate capital gains (or losses) based on the difference between the amount you paid and the amount you received after a sale.
Even if you don’t sell any of your stocks or bonds, you may have taxable events in your brokerage account. When shares pay dividends, that payment is taxable, even if you automatically reinvest the dividend in additional shares. The same goes for bond interest or dividends you receive in a money market or savings account. All of these types of income are taxable in the year you receive them, whether or not you withdraw the money from your account.
Calculation of the tax burden
Calculating your tax liability in a brokerage account can be complicated. In many cases, you may want to consider working with a financial advisor and/or tax accountant. However, every investor should know the basics of brokerage account taxation.
For income-generating investments, such as bonds, the interest is taxable as ordinary income. This means that you will pay your marginal tax rate on any income generated in the account. For example, if you earn $10,000 in bond interest and you are in the 24% tax bracket, you will owe $2,400 in income tax on that interest.
Tax on qualified dividends
Cash dividends paid by stocks and mutual funds are also generally taxable as ordinary income. An exception is if your dividends are “qualified”. Qualified dividends are essentially regular dividends from companies you’ve owned for a while. The rules can get complex, but holding a stock for at least 61 days can often be enough. The advantage of an eligible dividend is that it is taxed at the capital gains rate rather than the ordinary income rate.
Capital gains tax
Capital gains tax rates, as the name suggests, apply not only to qualified dividends, but also to capital gains, which are profits generated by the purchase and sale of capital assets, such as as stocks, mutual funds or ETFs. Capital gains tax rates are advantageous because they are generally lower than ordinary income rates. For example, in the 2018 tax year, tax brackets ranged from 10% to 37%. According to the IRS, however, the long-term capital gains rates for most taxpayers are 0% or 15%, with the maximum rate being 20%.
An important factor in correctly calculating capital gains tax is determining your holding period. For assets held for one year or less, capital gains are considered short-term, while those held for more than a year are considered long-term. This distinction is important because only long-term capital gains benefit from the reduced tax rate. Short-term capital gains are taxed at ordinary income rates. In other words, if you are in the 24% tax bracket, a short-term capital gain of $10,000 would trigger a capital gains tax of $2,400, while a capital gain term of $10,000 would generate only $1,500 in tax.
Whether you pay ordinary income tax or capital gains tax, you will owe these taxes the year you generate your profits, not the year you take the money out of your brokerage account. Leaving the money in your brokerage account or withdrawing it does not affect when or how much tax you will have to pay.
Brokerage Account Vs. IRA
An Individual Retirement Arrangement, also known as an Individual Retirement Account or IRA, is a tax-advantaged special account that can also be opened as a brokerage account. With an IRA, you can get a tax deduction on your contributions, depending on your income and whether or not you or your spouse are covered by a separate retirement plan at work. The IRS limits contributions to an IRA to $5,500 for the 2018 tax year ($6,000 for the 2019 tax year), with an additional “catch-up” contribution of $1,000 for individuals aged 50 and over.
In addition to potential tax-deductible contributions, income from an IRA brokerage account is tax-deferred. For example, if you earn $10,000 in dividends, interest, or capital gains in an IRA one year, you won’t have to report that income on your annual tax return. However, most distributions from an IRA are fully taxable as ordinary income.
This can make IRAs a double-edged sword when it comes to taxation. Yes, deductible contributions and tax-deferred growth are obviously very beneficial. But the downside is that you won’t benefit from lower tax rates on any long-term capital gains you might generate in your IRA, because all distributions are taxable as ordinary income.
For example, imagine that your entire IRA is invested in stocks and you hold those stocks for 20 years, eventually selling and generating a gain of $100,000. If that money was in a taxable brokerage account, you would owe 15% capital gains tax, or $15,000. However, when you take that money out of an IRA, you’ll pay your ordinary tax rate on the balance, even if it was a long-term capital gain. If you are in the top tax rate for 2018, 37%, you will owe $37,000 in taxes on this distributed balance.
When you invest money in a brokerage account, tax liability is an ongoing process. Whether you buy and sell capital assets like stocks or just sit back and earn dividends and interest, you’ll have to report that income to the IRS every year and pay taxes, unless your brokerage account is in an IRA. Keeping your profits in a regular, taxable brokerage account does not protect you from tax liability, just as withdrawing funds from a regular, taxable brokerage account does not trigger tax liability.