I’ve discussed the different aspects of opening tax-advantaged brokerage accounts in a number of articles, but I’ve never really explained the true extent of the benefits these accounts provide. Most people underestimate the amount of money capital gains tax (the tax you have to pay when you make money on an investment) can take away from your profits. In this article, I’ll explain what capital gains tax is and show how opening a tax-advantaged brokerage account provides significant savings in the long run.
Capital gains tax is a tax that must be paid whenever you sell an investment and make a profit. You have to pay long-term capital gains tax if you’ve held an asset for over one year and then sell it. If you buy and sell an asset in less than one year, you have to pay short-term capital gains tax, which is the same as ordinary income tax.
This means if you buy and sell an investment within one year, if you're day trading, for example, you will have to pay short-term capital gains tax. Depending on the tax bracket you're in, short-term capital gains tax is generally much, much higher than long-term capital gains tax. As such, when you're looking into something like day trading, make sure you account for the increased taxes you will have to pay. In short, the government incentives holding assets for over one year, giving a significant tax discount for long-term gains.
Long-term capital gains tax ranges from 0% to 20%, depending on your tax bracket, so the percentage you will pay depends on how much you’ve made. The chart below shows how much you will pay based on your profits.
(Taxes are extremely complicated, and I am not a tax professional, I won’t be discussing tax brackets, or taxes in general, in too much detail).
So, what does this mean for the average investor? Well, let’s say you invested $6,000 every year into an S&P 500 index fund in a taxable brokerage account, starting at the age of 22 up until the age of 60. You want to use this money to retire, so you won't have to work again.
Using the historical average return of around 8% per year, in 38 years, you will have around $1,433,647, meaning you profited around $1,205,647. For the sake of simplicity, let's also say you stop investing at the beginning of year 38, so all your gains are long-term.
Now, in year 39, when you’re 60 and ready to retire, you decide to sell your investment and realize your gains (realizing your gains means you've sold your investment and have the gains in cash). You now have $1,205,647 in profits, in cash.
Before we look at how capital gains tax will affect your profit, note three things: first, you’ve made a profit, so you actually qualify for the tax (if you lose money or break even, you don't have to pay any taxes). Second, you’ve held your investments for over one year, so your $1,205,647 qualifies as long-term capital gain. Third, your profit was over $445,850, which means you fall into the highest bracket possible. You won’t get taxed on $40,400, but you’ll get taxed at 15% on the next ~$405,000, and taxed at 20% on the last ~$750,000 ($40,400 + $405,000 + $750,000 equals around $1.2 million, the amount of profit you made).
Using this information, you owe the IRS a whopping $285,516, meaning you get to actually take home just over $920,131, much less than the original $1,205,647. While the amount you pay in taxes isn’t unreasonable, it is still a significant amount of money. The $920,000 in profits may still seem like a lot, but if you had invested that same $6,000 in a Roth IRA using post tax income, you would have paid $0 in capital gains tax, taking home the entire $1.2 million!
This calculation shows the damage capital gains tax can inflict on your profits, and the benefits a tax advantaged brokerage account like the Roth IRA can provide. Note that there are a number of different aspects to investing in an IRA, like the minimum age you can start withdrawing at, and the maximum you can contribute. I’ve written articles detailing both IRAs and 401(k) plans, and articles on exploring the differences between investing in a taxable and tax advantaged account. Make sure to explore all the choices and understand all the details when deciding where to invest.
I hope this article helped you gain a better understanding of capital gains tax, its implications when it comes to investing, and why a tax-advantaged brokerage account can be extremely beneficial. I’ll catch you in the next one!
I used this site for all my tax calculations: https://www.calcxml.com/calculators/inc06?skn=#results
And this site for my investment calculations:
*As always, I have to include the obligatory, “remember, I am not a financial professional, so make sure to conduct your own research before making any decisions”.