There are very few things in investing that we can control. We cannot control when our investments go into a tailspin. We cannot control which asset class is going to perform best in a given year.
We can, however, control the tax implications of our investments by fully understanding types of brokerage accounts and planning accordingly.
When starting out, it’s tempting to hold all of your investments in an IRA, 401(k), or other tax-deferred account, since contributions are immediately tax-deductible. This, however, could be detrimental to your returns, depending on the investments you make. First, let’s outline the benefits and limitations of tax-deferred accounts.
The main benefit of traditional and SEP IRAs and 401(k)s is their tax- deferred status. Anything you contribute is deductible from your gross income for that tax year. All capital gains (including dividend reinvestment) are taxed when you begin to withdraw funds from the account. The primary detractor for such accounts is that they are “illiquid,” that is, they cannot be sold cheaply. Cashing in before you reach retirement age will penalize you 10% right off the top. Also, withdrawals are taxed as ordinary income, not at the lower rates that capital gains from a taxable account would be taxed. Finally, capital losses cannot be written off, since the investments made were pre-tax, and have essentially already been written off.
Roth IRAs present their own set of difficulties in that any contribution is after-tax. In many ways this is better than traditional IRAs, mostly because any capital gains or interest earned is not taxed upon withdrawal. In this way, any gains made in a Roth IRA are tax-free.
However, if you experience a loss in your Roth IRAs, it is difficult to claim the capital loss on your taxes. You have to close all of your Roth IRA accounts and claim them as a gross loss (you will not be penalized, since there was no gain made; and you will not be taxed, since it was after-tax contributions). Then you cannot re-open your Roth IRA until the next tax year. As a result, it is best to keep Roth IRA investments low-risk.
Sure, you want to maximize your returns, but you want to be able to write off your losses from volatile investments, too.
With all of the retirement accounts available, including the new hybrid Roth 401(k), traditional taxable brokerage accounts have gone by the wayside. But they are an important part of any investment portfolio, as they can be very tax efficient, especially for buy-and-hold strategies, where your capital gains will be taxed as long-term.
If you hold a security in a taxable account for over one year, it is considered a long-term capital gain. This is taxed at 5% or 15%, depending on your tax-bracket. If you hold the security for under one year it is a short-term capital gain. Short term gains are taxed as regular income. It pays to hold on for a year in a taxable account.
Frequent trading can be very detrimental to overall returns, since each short-term gain is taxed as ordinary income if held in a taxable account. By limiting trading to a Roth IRA one can sidestep this (remember, a Roth IRA is all after-tax dollars, so you will not be taxed for gains, regardless of whether they are short- or long-term). This, of course, clashes with our previous assertion that Roth IRAs should hold low-risk investments, because of the difficulty of writing off capital losses.
The best solution is to hold multiple accounts: A Roth IRA and a 401(k) or SEP IRA should hold the bulk of your retirement investments. A supplemental taxable account should be used only for very long-term investments to minimize taxes. Limit short-term trades to a small Roth IRA (less than 10% of your total portfolio, as you do not want significant capital losses in your Roth IRAs, since you can’t write them off).
The multiple account approach may be a little more complicated than holding all of your retirement in one account, but it is the best way to limit your tax exposure.
You should have at least three stocks (or one mutual fund) in your first purchase. And if you are going the high-risk small-cap route with one of your investments, be sure that the rest of your investment (50%) is in one or two larger, more established companies, in different sectors than your small-cap find.
It’s important to monitor your first investments, but don’t obsess about it. If you check its price more than once daily, I would suggest getting a dog or another hobby. There are better ways to spend your time than hitting the Refresh button.
But you will want to take not of your investment’s performance. If you see it fall more than 8%, take a look at recent news releases and see if there is something damaging that may cause it to fall further. With small caps, you will see dips and rises on the order of 10%, but it is not always a sign of doom or success ahead, so don’t get too excited about it. But if the company consistently underperforms and the stock shows signs of falling again, you may want to re-evaluate your position and cut your losses.
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