FP - Taxes Lesson

Taxes

Saving and investing are great ways to prepare for the future financially. We already know that there are many things to consider when making investments, but one of the most important considerations is taxes. Taxes are important because they have the potential to lower your return.

Savings and investments can be taxable unless they exist inside of tax advantage plans. Inside tax advantage plans they can be either tax exempt meaning they are not taxed at all, or they can be tax-deferred, meaning they will be taxed as funds are withdrawn from the plans at a later date.

Tax-exempt funds provide tax-free growth within the plan and while you don't get a tax break for contributions to the plan, you also don't pay taxes on the earnings while the money is growing in the fund and you don't pay taxes on regular withdrawal from the fund. Tax-exempt investments include municipal bonds, health savings accounts, and Roth IRAs. A health savings account is tax-advantaged medical savings account available to taxpayers in the United States who are enrolled in a high-deductible health plan (HDHP). The funds contributed to an account are not subject to federal income tax at the time of deposit

Tax-deferred funds give you a tax break for contributions to the funds and your contributions grow tax-free, but you will pay taxes on withdrawals from the fund. Traditional IRAs, annuities, and retirement plan accounts fall into this category. Annuities are a series of payments at fixed intervals, guaranteed for a fixed number of years or the lifetime of one or more individuals. College 529 plans are also considered to be tax-deferred, but taxes are not paid on withdrawals if the money is used for qualified college expenses.

Savings and investments can be taxed in one of two ways: either as ordinary income or as capital gains. Anything considered ordinary income is treated just like the income from your paycheck. In our progressive tax system, where the more you make the higher the percentage you pay, ordinary income tax rates run from 10% to 39.6%. Interest, dividends, and investments held for less than a year will all be treated as ordinary income.

To encourage taxpayers to invest for the long-term, special rates are given for investments held for more than a year. These transactions are called capital gains and the rates for capital gains tax run from 0% to 15% unless you are in the highest income tax bracket where they are 20%. Capital gains can be offset by capital losses. Another important point about capital gains: you can't be taxed unless the investment is sold. Holding on to investments that increase in value will not cause you to pay a tax.

Tax Strategies

Three tax strategies can help you keep more of your investment rather than pay your earnings out in taxes. Review the presentation below to learn more about these strategies.

Self-Assessment

Try the sorting activity below to see how much you understand about investing and taxes.

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