How tax-advantaged accounts work
You’ve probably heard the term “tax-advantaged account” or maybe “tax sheltering” before, but what does it really mean and is it something you should be worried about?
Capital gains, dividends, and interest income
When you invest in a stock or a bond, you trade your cash for that investment. Those investments then provide you with a return in a few different ways. Stocks can increase in value creating capital gains, or they can pay out dividends to investors from company profits. For instance, if you bought a share of Tesla at $200 per share and the share price increased in value to $250, you would have generated $50 in capital gains. Or if you owned 100 shares of GE, and they paid shareholders a $1 dividend per share, you would have $100 dividend income. Bonds can also generate capital gains if they increase in value, and when they pay interest to the bondholder, they create interest income.
ETFs and mutual funds, which are typically collections of stocks and bonds, can also generate the same types of capital gains, dividend, and interest income.
It’s great when you have investments that pay you back right? But there’s one catch: Uncle Sam wants his share of the investment returns as well. Capital gains are taxed based on how long you held the investment and your income, qualified dividends are taxed based on your income, and non-qualified dividends and interest income are taxed at your marginal tax rate. Those taxes can be a real drag on your after-tax returns.
Wouldn’t it be nice to avoid them?
