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Financial Fact or Fiction: Reinvested investment income is taxable in a non-retirement account.

  |   Income Tax, Investment Planning

Fact or Fiction

If you reinvest the interest, dividends, and capital gains earned in a non-retirement account, you don’t have to pay tax.

FICTION!

 

Confusion surrounding income earned in non-retirement accounts is not unusual.

For many people, especially early in their careers, investing occurs solely within qualified retirement plans.  As a result, concerns about taxable income generated from investments is a non-issue because investment activity inside a retirement account is not reportable for income tax purposes.  However, once individuals begin investing outside of retirement accounts, the confusion begins.  Numerous clients have told me that because they reinvest the dividends earned on the investments in their taxable (non-retirement accounts), they don’t have to pay tax until the investments are actually sold.  This is not true.

What do you need to know?

Income earned in a non-retirement account is taxable

If you are saving and investing in a non-retirement account, dividends, interest, and capital gains generated in the account are taxable (unless the interest earned is from tax-exempt bonds).  This is true even if the earnings remain in the account and are reinvested back into the same investments that generated the income.

Schedules B and D on your income tax return are great resources

Assuming Schedule B on your individual income tax return is completed properly, it will provide a list of all of the interest and dividends earned in non-retirement accounts, including bank accounts. By virtue of inclusion on Schedule B, the income is included when calculating taxes. (In fact, this schedule is a great tool for me when working with clients as I often learn about assets that clients have forgotten to mention!)

Schedule D is where all capital gains and losses are reported.  Even if you haven’t sold any investments yourself, you may still be subject to realized gains and losses if you hold mutual funds.  This is because mutual funds are required to distribute their gains and losses to shareholders, even if the shareholder did not take any action to cause the gain or loss.

If you have never paid much attention to these Schedules on your income tax return, now is a great time to do so!

Tax efficiency matters

Many people simply hand their tax documentation to a tax preparer and don’t think twice about what is actually reported in that documentation, at least until they see their tax bill.

However, if you are investing outside of retirement accounts, you need to pay attention to how the income generated from your investments is taxed.  After all, when it comes to investing, it is not just what you earn that matters, but how much you keep after paying taxes (and fees).

How do you know if you are holding the most efficient investments in your non-retirement accounts?  The chart below from Fidelity provides a good summary and the “Taxable” column is where you should look.  Of course, each person’s situation is different and there may be very good reasons to deviate from the recommendations in the chart below.

Source: Fidelity – Why Asset Location Matters, March 15, 2017

AUTHOR - Tammy Wener

As co-founder of RW Financial Planning, Tammy oversees the financial planning process for all clients and manages the day-to-day operations of the firm. She truly enjoys getting to know her clients and is not shy about asking questions. Tammy has 15+ years of experience in the financial planning and estate planning fields and has worked with a broad range of clients including: couples simultaneously planning for financial independence, caring for their parents, and saving for college; newly widowed and divorced women looking to become more financially literate; young couples just starting out; families juggling the demands of a child with special needs; and financially independent individuals and couples exploring “what comes next.”



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