Basic Tax ConceptsThe effect of taxation on income and accumulated value is a key investment consideration. Some important terms:
- After-tax/pre-tax investments. Is the income you put into an investment subject to taxation? If so, it is an after-tax investment. Typically, savings accounts and most trading in stocks and bonds involve after-tax income. Pre-tax means that you do not pay taxes on the income you invest—either because the tax is never deducted (such as with contributions to a 401(k) plan) or because you can write your investment off as a tax deduction (like a portion of your contribution to an individual retirement account).
- Capital gains tax. In order to encourage investment, capital gains (profits on securities sold) are taxed at a rate lower than that of regular income, provided you hold the investment for more than 12 months. These are referred to as long-term capital gains. If you hold a security for a year or less, your capital gains are taxed as regular income. Some investments, such as mutual funds, that reinvest dividends may show appreciating values; however, those values are not all capital gains. Reinvested dividends add to the basis of an investment, which needs to be subtracted from the value to accurately calculate capital gains.
- Tax-deferred. This means that the value that builds up in your investment is not subject to taxes until you take it out as income. Most retirement plans and annuities are tax-deferred. Tax-deferred investments usually entail increased taxation as a penalty if you withdraw your funds before a certain date.