Monday, August 11, 2014

After Tax Investments: Dividend Income > Tax Advantages

After tax investments should be a big part of your retirement plan as I previously posted.  Not only can you reduce your taxes, your after tax investments can also be accessed now without paying an early withdrawal penalty tax to the IRS. So they are a great of source of funds to pull from in the event of an unexpected emergency or investment opportunity.  But what about the tax on the profits?  That is a great question.  In fact, I received this tweet as I was writing this post:

In most cases your profits from your after-tax accounts will either be classified as dividends or capital gains. Here is how the IRS defines dividends:

Dividends are distributions of property a corporation pays you because you own stock in that corporation. 
If you read between the lines you will notice, that dividends are really your share of the profits that have already been taxed once by the IRS (technically Uncle Sam but that is splitting hairs). Distributions that are a return on your invested money are taxed as capital gains to the extent the distribution exceeds your basis.  So now that the entity is distributing already taxed profits to the shareholders these distributions are call dividends.

Ordinary or Qualified Dividends:

The dividends you receive will be classified as either "ordinary" or "qualified."  This is very important from a tax standpoint, because "ordinary" dividends are taxed as ordinary income at your ordinary income tax rate.  But "qualified" dividends that meet certain requirements can be taxed at the favorable capital gains rates.

For more information about qualified dividends see IRS publication 550.

Long Term Capital Gains Rate:
Long Term Capital Gains Tax Rates are determined by the individual's personal income tax bracket.  Below are the 2014 Long Term Capital Gains Tax Rates as they correspond to personal income tax rates.

Personal Income
Long Term
Tax BracketCapital Gains Rate
10% - 15%0%
While taxes on ordinary income can range from 10% to 39.6% your capital gains rates can be much lower or even 0%.  So while your post tax investments have already been taxed, the profits on them will typically be taxed but at much lower or favorable capital gains rates.  So the taxes you pay on the profits from your investments in your after tax (investment) accounts can be taxed at much lower rates than the funds in your retirement accounts will be taxed at.

Now make sure you get this point, the tax on distributions (not just profits but all distributions) from retirement accounts are at the higher ordinary income tax rates and not the favorable capital gains rates.  So even though the profits made in your retirement accounts may be the same as capital gains they are taxed at ordinary income tax rates because you never paid tax on the money invested into the retirement account.  So of all your money taken out of retirement accounts is typically taxed at the higher ordinary income tax rates.

So once again, you can see your investment accounts (after-tax dollars) should be a powerful tool in your plan for retirement.  While your funds in retirement accounts will be taxable as ordinary income when you take them out, your post or after-tax investments have already been taxed so when you take those funds out they are technically tax-free at that point while the profit can be taxable but often at favorable capital gains rates.  So in retirement it would be nice to pull from retirement accounts up to your standard or itemized deduction and exemptions so that you do not pay tax on them. After that you can pull from post tax investments and only pay tax on the untaxed portion of the profits. In theory then you could have a tax free retirement, at least at the federal level based on today's tax laws.

For more information about retirement planning see my post: How to Avoid Income Taxes in Retirement.

In addition you can lower the overall taxes you pay over the course of your life by having funds in investment accounts and being able to pay the favorable capital gains rates on the profits instead of the higher ordinary income tax rates you will pay on retirement accounts.  It is even possible that you will pay no tax on the profits from your investment accounts if you are in the 10 to 15% tax bracket when you recognize the profits.  So while putting money in retirement accounts can reduce your taxes in the year of the contribution of those funds, the taxes are really only deferred until later when you take the money out of the account.  Additionally your money in after tax investment accounts can be accessed before you turn 59 1/2 years of age without paying the 10% early withdrawal penalty you would pay on early distributions from your retirement accounts.

So while retirement accounts have their place, their real value to you is only in deferring and not in minimizing taxes.  However, by using investment accounts you can reduce taxes and increase liquidity allowing you to "jump on" other investment opportunities when they arise.  This is a greatly misunderstood concept but with this information you are now empowered to make good decisions that will benefit you greatly now and in retirement.  I would be happy to help you take advantage of these tax planning opportunities.

With dividends too there are also many tax planning opportunities for you regarding when take money out of your personal or family C Corporation.    Since this income can be taxed to you twice you want to plan to minimize those taxes.  Up front input from an experienced CPA can help you greatly to minimize your tax burden.

For more information on dividends see IRS tax topic 404.

Finally, the IRS added the Net Investment Income Tax starting in 2013.  So you need to take this into consideration too when you are doing tax planning for your investments and retirement.  See my post on this tax by clicking here.

The CPA Superhero wants to help you to succeed in business, life, and in retirement.  While my main business is preparing tax returns, I also work with clients to setup accounting systems to start, manage and develop their business(es) and develop and implement a financial plan. Contact me using my information below to schedule a free introductory consultation up to a half hour. 

Jeff Haywood, CPA

The CPA Superhero

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My posts contain general information that does not fit every situation, they are not all inclusive, and as always for your tax situation everything "depends on facts and circumstances."  In addition, the information/IRS requirements are always subject to change.  So call me to talk about your specific facts and circumstances and what you want to accomplish.