You know what I love about blogging? It’s that you learn about important things that you probably weren’t going to go searching for on your own. That’s exactly what Matt from Mom and Dad Money did for me when he wrote an epic guest post for My Money Design about two weeks ago. Even though there were a lot of great points buried within the text, one of the things I took away from it personally was the mention about how a long term capital gain (much like your dividend income) is taxed at a lower and more favorable rate than your ordinary income.
Taxes? Time to Stop Reading This Post …
Wait! Don’t leave. I promise not to bore you too much with a bunch of technical jargon.
Just know this:
- This can be beneficial to your finances in the future.
Why do I think that?
Everyone always thinks that your 401k and IRA are the only way to go when it comes to saving for the future. While both are great, remember that no matter what setup you choose you will ultimately pay taxes on them. These are called ordinary income taxes. If you’re a regular middle class guy like me, then your ordinary income tax rate is probably 25%.
- If you have a traditional setup, you’ll pay them later when you retire.
- If you have a Roth setup, you’ll pay them now.
While both are certainly a benefit, if you plan to retire early (like me) before age 59-1/2, then you’re going to need some portion of your money to not be locked up in prison. You’ll need to be able to access it. You’ll need a regular taxable account.
But here’s where the beauty comes in: Not all types of taxable accounts are the same. Some investments are better than others.
Tax Advantages on Dividend Income:
As a dividend stock investor I’ve known and appreciated for some time that if I receive income from my dividend stocks, I could enjoy a lower tax rate (around 15% instead of 25%). These would be called qualified dividends.
So my strategy for sometime has been this: Build up a nice pool of dividend stocks and simply live off the dividend income. Aside from a number of other great benefits, I was in love with the tax advantage.
But the problem is that you always pay taxes no matter what because dividend income (regardless of what you do with it) is “income”. So I’d still be on the hook for the 15% with all the income I receive.
How a Long Term Capital Gain Can Help Lower Your Taxes:
And so this brings me back to Matt’s post.
For some reason I had not explored too deeply the tax rates on other types of investments besides dividend income. I was pleased to learn that long-term capital gains had their own set of wonderful tax breaks as well.
Basically if I were to buy a share of stock (for now let’s pretend it’s NOT a dividend paying stock) and hold it over one year:
- It would qualify as a long term capital gain.
- I’d owe 15% instead of 25% in taxes on however much it increased by (i.e. the gain)
So this gives me yet another tool to use for my early retirement strategy besides just dividend stock investing!
But wait! There’s more:
- You only pay the long term capital gains tax when you actually sell the stock! That’s great news for a long-term investor like myself. It means I’ll be able to pay no taxes for quite some time as long as I hold on to my investments. This is different from having to pay 15% every time I receive dividend income. Example: Let’s say I buy a group of stocks at $10,000. Five years from now the stocks have increased to $20,000 and I finally decide to sell them. I’d pay the 15% capital gains taxes in that fifth year, and not during years 1-4. So by holding on to them for five years, I was able to defer my tax payments. When you compare this to a traditional IRA where you will eventually pay 25% on your gains, there can be some pretty lucrative and beneficial reasons to having some of your money in these types of accounts.
A Great Tax Resource:
If this is all too confusing or you’d simply like a great resource on this topic, I’ve come to learn that Fidelity has an outstanding tax guide that pretty much spells all this out. In addition to defining all these terms in more detail, the post also includes some easy to follow tables that clearly show you which bracket you’d be for the current year. It’s a valuable reference tool that I’m sure I’ll be coming back to for years to come.
Readers – How do you use long term capital gains to your advantage? Does anyone else have any useful tax tricks to lower their overall annual bill?
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