How to Reduce Tax Impact on Your Stock Investment Earnings

Ah, we come to our favorite subject, taxes! The objective in the stock market is to make money, and every time that you make money, you are going to find yourself in a position of having to pay taxes on it. Unfortunately, it’s a reality we can’t escape. You might delay it, but at some point, you’re going to have to pay.

There are many different issues you need to be aware of when it comes to taxes. This isn’t a tax advisory guide, and you should consult an accountant to make sure you’re doing everything right. However, we’ll take a brief look at some of the main issues.

Capital Gains

Suppose that you hold an asset, and the price appreciates. If you sell it, you’ll realize a capital gain — in other words, you made money. When you make money by selling appreciated assets, you owe capital gains tax. The important thing to consider is how long you held the asset.

If you held the asset for one year or less, this is a short-term capital gain. The bad news about this is short-term capital gains are considered ordinary income. That means you’ll pay the regular income tax rate on your gain.

If you hold the asset for longer than a year, even if it’s just a day, then it becomes a long-term capital gain.

For some reason, Congress has decided that they know that holding assets for an arbitrary period that they made up is better, and so long-term capital gains have very favorable tax rates. These are much lower than income tax rates.

The bottom line here is that you’ll want to take into account how long you have held an asset (aka stocks) when selling. If you are a long-term investor and planning to hold your investments until retirement, this means that you will be paying long-term capital gains taxes on your investments when you sell them off to get the money. Of course, if your retirement is in the distant future (more than ten years away), it’s hard to say what the laws are going to be.

Dividend Income

The important thing to note about dividend income when considering taxes is that it’s considered to be ordinary income. There isn’t anything special to consider dividend income. The one exception is dividends paid by an MLP. That’s because they aren’t technically dividends and you’re considered a “partner” in the business. In that case, you are able to deduct depreciation from your taxes. The company passes it on to the “partners.” This has huge implications. Many investors in MLPs are able to enjoy their income from the investments virtually tax-free. It’s a little complicated, so if you start putting money into MLPs, you’ll want to consult an accountant. The company will be sending you the appropriate forms.

Individual Retirement Accounts

One of the advantages of individual retirement accounts or IRAs is that they allow investments to grow inside of them tax-free. You can utilize this to your advantage. One way to do so is to buy dividend stocks inside the IRA and then reinvest the dividends. That way, you can continually grow your account and grow it beyond the usual limitations.

Expenses

Deducting expenses related to your investment might be problematic. The IRS isn’t too friendly when it comes to deducting expenses related to investing. There is one exception, and that is if you are a day trader. Then a day trader can deduct expenses like publications they read and all the computer equipment and software services that they sign up for. But if you are doing ordinary investing, that might be a hard sell.

One way to get around it is to set up a business to run your investing. Then have the business buy all the equipment and so forth. Of course, this will inject other complications into the situation, so you’ll have to weigh the pros and cons in order to determine whether or not it’s really worth the extra hassle. Quite frankly, in most cases, it’s not going to be.

Understanding Your Brokerage Account and Statement

You’d be surprised to know that most extremely wealthy people have taxable brokerage accounts. It provides an avenue for them to benefit from the stock market and diversify their income stream. As we’ve discussed earlier in this guide, if you want to invest huge amounts of money and be a successful investor, you have to open a taxable brokerage account.

What is a Brokerage Account?

A brokerage account is a taxable investment account that you can use to buy and sell stocks and other securities. As the name suggests, it’s opened through a brokerage firm. It’s much like a bank account. You have to deposit money into your account before you can start buying and selling stocks.

You can deposit money into your account through checks or electronic funds transfers. You can also wire money to your account.

Type of Investments a Brokerage Account Can Hold

Brokerage accounts are not just for stocks. There are a number of securities that a brokerage account can hold, including:

Common Stock — This represents partial ownership of a company. It usually comes with voting rights.

Preferred stock — This stock usually comes with high dividend payments, but it’s more expensive than common stock. Preferred stock shareholders typically don’t have any voting rights.

Bonds — A bond is a debt security. When you purchase a bond, the issuer (usually a government entity) owes you money. You earn money from bonds through interest rates.

Mutual Fund — A mutual fund is funded by different shareholders. It’s basically a pool of money that’s invested in different securities. It’s relatively easy to invest in a mutual fund. Plus, it’s usually managed by a financial professional. You can buy different mutual funds, too, so you don’t have to put all your money into one mutual fund.

ETF — An ETF, or Exchange Traded Fund, is a basket of different securities that are traded like a stock. An ETF is a good investment because it has trading flexibility. It helps you diversify your investment portfolio and manage risk. It’s also cheaper than a traditional mutual fund.

REIT — A real estate investment trust, or REIT, is a company that either finances or operates income-producing real estate properties, such as commercial buildings. REITs usually own various income-generating real estate companies, such as hospitals, warehouses, hotels, and malls. You can invest in publicly traded REITs using your brokerage account. 

Money Market and Certificate of Deposit — A money market account generally represents pools of liquid mutual funds. It has higher interest rates and has a limited check-writing capacity. A certificate of deposit is basically a time deposit. For example, you agree to deposit $10,000 into your account. You can’t withdraw that amount for five years, but you’ll earn an interest rate throughout this period. So, if you earn $1,000 in interest per year, you’re going to earn an extra $5,000 for your deposit after five years.

Cash Brokerage Accounts and Margin Brokerage Accounts

There are two main brokerage account types — cash accounts and margin accounts. A cash brokerage account requires you to deposit cash into your account. You’ll have to pay for your transactions in cash and in full when you have a cash brokerage account. 

A margin account, on the other hand, allows you to borrow from the broker using some of your assets as collateral to buy securities.

If you’re a beginner, it’s best to go for a cash brokerage account. Why? Well, margin brokerage accounts are complex and will get you buried in debt if you’re not careful.

Limits of Money You Can Deposit in a Brokerage Account

As previously mentioned, other investment plans such as the IRA and 401(k) have limits, but taxable brokerage accounts do not, so you can deposit and invest as much as you want. That said, keep in mind that you do have to pay taxes for this type of investment.

How Many Brokerage Accounts Can One Have?

You can have as many brokerage accounts as you want, but keep in mind that most brokerage firms require a minimum deposit amount of $500 to $2000, so opening multiple accounts can be costly.

However, if you have unlimited resources, you can open multiple accounts with different brokerage firms.

Difference between a Discount Broker and a Full-Service Broker

There are two general types of broker: 

  • A full-service broker and
  • A discount broker

A full-service brokerage account is great because it comes with a dedicated broker. You can call, text, or email him should you want to make an order. This broker usually knows you personally, and sometimes he knows your family. He also knows your finances intimately. He’s like a financial advisor. You usually have to meet him regularly to discuss your portfolio.

Full-service brokers usually charge high commission fees. A discount broker, on the other hand, doesn’t charge much. But, this type of broker usually operates online. A discount brokerage account is like a Do It Yourself (DIY) investment plan.

So, what should you choose? Well, it depends on what your priority is. If you are on a budget and you really want to save money, it’s best to open a discount brokerage account. But, if you really want to have a financial adviser, it’s a great idea to open a full-service brokerage account.

Understanding Your Broker’s Statement

A broker’s statement is a monthly report that contains the activities in your brokerage account. You can choose to receive a paper statement, but you can usually just check it online as well.

It pays to examine your statement carefully so you can spot some kind of fraud. When you first receive your income statement, you have to check to see if it looks professional. An unprofessional-looking statement is a red flag. Legitimate brokerage firms invest time and effort to make sure that their reports look polished and professional.

Here’s what you’ll find in your broker statement:

  • Statement Period Date — A broker’s statement reports how your investment is doing at a specific period of time, usually a month. If you don’t see a statement period date, that’s a red flag.
  • Account Number, Account Name, and Address — This obviously contains your taxable brokerage account number, your name, and your present address. Be worried if this information is incorrect.
  • Contact Information — This contains the contact information of your broker. If you don’t see this anywhere in the statement, the brokerage firm you’re dealing with may be dubious.
  • Name of the Clearing Firm — This contains the name and the contact number of the clearing firm that holds your investments. FINRA rules require brokerage firms to place this information in their statements. So, be alarmed if you don’t see this anywhere in your statement.
  • Account Summary — This provides insight with regards to how your account is doing. This can help you review and assess your investment decisions.
  • Fees — This covers the transaction and commission fees you’ve paid within the time period.
  • Account Activity — This is where you can see the stocks you’ve bought or sold within that particular time period.
  • Margin — If you have a margin account, you’ll find this section. This contains the amount you’ve borrowed to purchase stocks and other securities.
  • Portfolio Detail — This section breaks down your investment by types like stocks, bonds, or mutual funds.

Learn The Right Investment Mindset By Reading Books

Mindset plays a large role in successful investing. My reading list contains many books on mindset.

A few weeks ago, I read the Rich Dad Poor Dad book and found it quite fascinating.

In Rich Dad Poor Dad, the author explores the steps to becoming financially independent and wealthy using autobiography and personal experience. 

Narrative writing and framework characterize this book. Not technical insights or investment math, but anecdotes with nuggets of supposed wisdom, is the focus of this book.

The author compares his biological father’s (an intelligent, but financially inept father) lessons with the lessons his friend’s father teaches him (an uneducated, but brilliant and wealthy father).

In Kiyosaki’s life, this weaves through as he learns from the rich father and rejects the advice of the poor father (thereby eclipsing typical working-class attitudes).

However, some of the concepts in this book are questionable. Learn more about my thoughts about Rich Dad Poor Dad in my Rich Dad Poor Dad review.

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