Better Than Basics: Level Up Your Financial Literacy Part 2

In Part One of our series, we discussed how knowing the basics of financial literacy is helpful but it’s not enough. Oftentimes the losses are simple misunderstandings about the taxation of different investing accounts. To start leveling up your literacy, we associated some common account types and their typical tax classifications. Now, it’s time to kick it up a notch! In Part Two, you’ll learn about short versus long term gains, ordinary income tax rates, and calculating profit. 

Short Term Capital Gains /(Ordinary Income Tax Rate)
Simply put, short term capital gains are the profit on an investment that is held for less than 12 months.  These gains are taxed at the same rate as your ordinary income. Your ordinary income rate is based on your filing status and your taxable income. It’s important to know that tax brackets are established annually and marginal - this means that rates change annually and the marginal tax rate is tiered.

Long Term Capital Gains 
Long term capital gains are the profit on an investment that has been held for 12 months or longer. The taxation on the profit is broken down into three tiers based on your filing status and federal income. These tiers will change annually depending on taxable income.

Non-Taxable or Tax-Free  
Out of the three taxation methods, this type is my favorite because the profits and the income from these funds are not subject to taxation. However, there are also many scenarios where you can lose tax free status. So, make sure to consult a tax professional before making updates in your account and to help you get a better understanding of those restrictions. 

Calculating Profit
Since you have a good understanding of taxation methods, let’s take a few seconds to create the profit calculation. Profit is the difference between the purchase price and the sell price. The purchase price can be found on your investment statements and is called “cost basis”. Subtract the purchase price from the selling price to get your profit. 

Calculating Capital Gains
Taxation will depend on 2 factors: current tax rate and type of gain short/long. If it’s short, you add your ordinary income and be taxed at the end of year income. If it’s long you need to find your tax rate and then the corresponding long term capital gains rate. The profit will be taxed at that rate. You may notice that only brokerage accounts track this because they are not tax advantaged - unlike your retirement accounts.

As we wrap up this series, I want to reiterate the different tax triggers for each account. Brokerage accounts are triggered by the sales of positions in the portfolio and not by a withdrawal from your account. Pre-tax retirement accounts are always taxed at the ordinary income rates. Lastly, Roth accounts are tax-free assuming no restrictions apply. Remember to discuss these decisions with a tax professional.

Having a better understanding of taxation rates for accounts leads perfectly into our next topic.  We'll conclude this series by learning to properly structure withdrawal from these account types to limit your tax liability and improve your financial outlook.

If you fail to plan, you plan to fail.

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