How Do My Investments Impact the Way I File My Taxes? Find Out on the Money Confidential Podcast

As most financial advisors will tell you, investing can be a great way to grow your own personal wealth. However, when it comes to filing your taxes when you have investments, there are a few things you need to know in order to avoid costly penalties—something that this week's listener on the Money Confidential podcast had to learn the hard way.

For the sixth and final installment of our "Taxes in Ten" series, we talked with Lorraine (not her real name), who, along with her husband in 2018, cashed out some of their mutual funds to purchase their first home. Then, in 2019, Lorraine and her husband did their taxes as usual, because they hadn't received any paperwork or notices from the brokerage company with which they cashed out their investments.

If you've been following along with the podcast, you probably already know how this story ends: with a dreaded red letter from the IRS. Lorraine and her husband owed $4,000 in back taxes for the capital gains taxes from their investments.

With a little more info about how investments affect taxes, this penalty could have been avoided. That's exactly what Money Confidential host Stefanie O'Connell Rodriguez sat down to talk about with Kristin Myers, editor-in-chief of The Balance, and Caleb Silver, editor-in-chief of Investopedia.

If you're just wondering whether or not you need to pay taxes on your investments, well, the answer depends on a few things. These factors include whether or not you profited on the investment, how long you had the investment before selling it, and your income level.

"Capital gains taxes are the taxes on the profit you make in an investment," Silver says. "So that could be a stock. You bought it for 10 bucks, you sold it for a hundred bucks. Your profit is $90."

If you held that investment for less than a year, SIlver explains, you'll need to pay short-term capital gains based on your income level. If you held the investment for more than a year, you'll need to pay long-term capital gains. "Any tradable asset—that applies to even gold, even commodities—if you traded anything in the near or short term or the long-term and made a profit on it, you could be taxed on that asset as long as it's tradable and there's a record of it," Silver says.

The same rules apply to selling NFTs and cryptocurrency. "If you are buying and selling cryptocurrency throughout the year, or stocks and trying to cash in on short-term profits, you're going to owe a lot of short-term capital gains—and you probably didn't realize it at the time," Silver says.

But that's how you can get into a situation like the one Lorraine found herself in above.

The good news, however, is that you don't have to start paying taxes on investments until you sell or use them. This also applies to retirement accounts, like a 401(k) or IRA.

"When you start taking distributions, you'll be taxed on that, but you're not taxed on that money [when it's] just sitting there growing and compounding over time," Silver explains. "And that is why we try to encourage so many people to take advantage—if they have an employee sponsored retirement account, or if they're working for themselves to set up a retirement account—so they can make some of those tax-free contributions and let them grow over time. It costs you nothing in taxes as they grow; when you sell that's when you'll pay."

If you don't have 401(k) or similar benefits through an employer, or you're a small business owner, you can set up a Simplified Employee Pension (SEP) account, which will allow you to start making these contributions to a retirement account.

No matter your situation, a smart way to invest is to proactively consider the tax implications of your money moves—so you don't get hit with an unwanted surprise later on. Silver says these investing choices all depend on the type of investor you want to be.

"Those folks who are younger, or even have 10 to 15 good working years ahead of them, you're going to be long-term investors," he says. "You're trying to invest and put away money so that it can make you money while you're working, and then generate you income when you've stopped working or you're in retirement. So you don't want to do a lot of trading activity in those accounts. If you want to trade stocks or cryptocurrencies or non-fungible tokens, set aside 5 percent of your portfolio and do it there—the gains and losses won't be that great and the tax burden won't be that great either."

You can also give investments or stocks as gifts—but you should be aware of the tax implications first. The rules are the same for when you gift money. "So if you want to give your friend $1,000, that is going to be tax-free," Myers explains. "But if it's over $15,000, if you are a single person, then you're going to have to pay taxes. If you are married, you can give up to $30,000 and you won't have to pay any taxes on that."

For the full rundown on the tax implications of investments, check out the final episode of Money Confidential's six-part series, "How do my investments impact the way I file my taxes?" on Apple Podcasts, Spotify, Amazon, Player.FM, Stitcher, and wherever you get your podcasts.

Read the full transcript.