Taxable Accounts: Individual and Joint
With taxable investment accounts, you generally owe taxes each year on the dividends and other distributions paid to you that year. You may also owe taxes when you sell shares, depending on whether or not you’ve realized capital gains on the investment.
Taxation of Dividends
Most ETFs pay dividends, which are reported on your Form 1099-DIV. These are generally taxable, typically at your ordinary marginal tax rate (0-37%, Federal). For high earners, an additional 3.8% “net investment income tax” applies. Certain ETFs that hold stocks may distribute “qualified” dividends, which are potentially subject to lower tax rates (Box 1b). Some ETFs hold municipal bonds, which pay dividends that are partially or wholly exempt from federal and/or state tax (Box 11 of 1099-DIV).
Some ETFs make distributions and part of them are not taxed as dividends, but instead they are taxed as capital gains, or in other words, return of capital. Capital gains that are distributed are reported on Form 1099-DIV as well (Box 2a). These are usually minimal for the index-based ETFs used by Betterment (indeed, this is one reason why ETFs can be more tax-efficient than mutual funds). Return of capital is rare, but could apply, for example, to real estate ETFs that sell some of their holdings, and is reported in Box 3, 9 or 10 (See IRS Pub 17 for details).
Foreign Tax Paid
For ETFs with non-US holdings, the 1099-DIV can indicate foreign tax paid. This could happen when such ETFs have already paid foreign taxes on distributions made by companies in foreign jurisdictions, before passing them on to U.S. shareholders. To mitigate double taxation on the same income, the U.S. rules potentially allow for a deduction or tax credit for these amounts (Box 7).
Taxation of Capital Gains
We sell your shares when you withdraw, when we assess our fee, when we rebalance your portfolio, when we harvest losses with Tax Loss Harvesting+, when you change your allocation, when you adjust your portfolio strategy, when you transfer to another goal at a different risk level, or if we rebalance your Tax-Coordinated portfolio. When we sell shares that have gained value, you will owe capital gains taxes. If the investment has lost value, you now have a capital loss, which is used to offset other gains that you realized that year, and any excess loss may be deductible from your earned income, up to a threshold set by the IRS. Losses not used that year may be carried forward to future years.
Traditional IRAs or SEP IRAs
Traditional IRAs and SEP IRAs may afford a deduction against your ordinary income in the tax year during which you contribute funds, if you qualify based on your income. Any dividends you receive are automatically reinvested by Betterment, and grow tax-deferred until you withdraw. When you withdraw from the account, taxes are generally due at your ordinary income tax rate applicable at that time, both on earnings and on all contribution amounts that were previously deducted. Penalties may also be due if you don’t meet the withdrawal qualifications (e.g., you withdraw before age 59.5). Read more from the IRS on IRAs and SEP IRAs.
Roth IRA contributions are made with dollars you’ve already been taxed on—you don't get a deduction. However, at retirement, as long as you've held the account for at least five years and you’ve met the other qualified withdrawal criteria, none of the amount withdrawn is taxed. Any dividends you receive are automatically reinvested by Betterment, grow tax-free, and are also withdrawn tax-free. Read more from the IRS on Roth IRAs.
You can read more on how taxes generally work with various types of investment accounts in this article.
Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a qualified tax professional.
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