Basic Tax Concepts

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Basic Tax Concepts

The 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.