Taxation is one of those things we as investors usually don’t like to deal with. When you’re focused on your end goal of achieving financial independence you probably don’t take kindly to anybody withholding part of your earnings.
Vanguard’s tax withholding rules can be complicated but I dug through them and have summarized the answers here:
Will Vanguard withhold taxes? Vanguard will withhold at least 10% of withdrawals from qualified plans, such as 401(k) retirement plans. If you do not waive tax withholding, Vanguard will withhold federal and state taxes. You might be able to waive state tax withholding, even though federal taxes are being withheld. This depends on your state.
As you see tax questions can get complicated fast. So, let’s break this down a bit!
What is tax witholding?
Tax withholding is the process by which brokers and other financial institutions withhold a certain percentage of your earnings on an investment product. Usually, brokers are required by law to do so. With most brokers you will also have the option to opt-out of tax withholding.
Generally, the IRS wants taxes to be withheld to make sure investors pay up before receiving their investment distribution, similarly to how taxes are deducted from your employer’s paycheck preemptively.
Tax withholding is not necessarily a bad thing as it can help you stay on top of your annual tax burden. However, there are better ways to use the withheld money in the meantime.
How is portfolio income taxed?
Portfolio income is generally taxed at the capital gain tax rate. A taxable event happens every time you sell a security from your portfolio or receive dividend payments from your Vanguard ETF or mutual fund.
|Single||Married Filing Jointly or Qualified Widow(er)||Married Filing Separately||Head of Household||Trusts and Estates|
|Over $425,800||Over $479,000||Over $239,500||Over $452,400||Over $12,700||20%|
You might be able to declare your ETF dividends as qualified dividends and pay the lower long-term capital gains rate. This depends on how long you have held the fund in your portfolio. (Read: Are ETF Dividends Qualified?)
Do I have to pay taxes on my Vanguard account?
If and what type of taxes you have to pay on your Vanguard account depends on your holdings.
For a Roth IRA there are no taxes on withdrawals of contributions and even no taxes on earnings as long as you’ve held the account 5 years, you’re age 59½ or older, or a special exception applies.
For traditional IRAs contributions may be tax-deductible and earnings are tax-deferred. This means you’ll simply pay taxes later. The advantage here is that these tax breaks are not limited by your income or holdings.
Dividends and other capital gains are taxed at the standard capital gains tax rate (see above). However, your dividends may be considered qualified dividends which makes them eligible to be taxed at the long-term capital gains tax rate.
Does Vanguard withhold federal taxes?
Unless you have waived federal tax withholding, Vanguard will withhold 10% of withdrawals.
If you live outside the U.S. you may even be subject to a 30% tax withholding without a right to waive. This is because Vanguard is required by law to withhold the maximum federal taxes due on your distributions. You are also unable to defer taxes if you live abroad.
If you live in the U.S. you are always able to waive federal tax withholding for any of your investment products.
Does Vanguard withhold state taxes?
By default, if you have not waived federal tax withholding, Vanguard will also withhold state taxes. If you have waived federal tax withholding Vanguard will generally also stop withholding state taxes.
There are some states you are able to waive state tax withholding even though federal taxes are still being withheld such as Michigan, Missouri, Oklahoma and Oregon. However, this remains the exception to the rule.
Does Vanguard report to IRS?
Vanguard is required to report to the IRS cost basis information about shares that were acquired after certain dates.
Vanguard will report cost basis information to the IRS for stocks and ETFs organized unit investment trusts (UITs) starting on January 1, 2011. For mutual funds, regular ETFs and stocks acquired through a dividend reinvestment plan (DRIP) reporting is mandatory since January 1, 2012.
Acquisitions of bonds and options are reported to the IRS starting either on January 1, 2014, or 2016 depending on their complexity.
What is the standard mandatory federal tax withholding for withdrawals?
Standard mandatory federal tax withholding for withdrawals requires brokers and other financial institutions to withhold 10% of withdrawals.
You can usually opt-out of this requirement by filing a Return of Excess request with your broker.
As we have seen, tax withholding can be complicated.
In general, you should assume that Vanguard will withhold taxes at 10 % of withdrawals unless you have instructed them otherwise. You can elect to waive federal tax withholding which will also waive state tax withholding.
Capital that is withheld is dead capital. It’s not working for me. It’s not accruing interest. That’s why I always prefer waiving tax withholding and receiving the full share from my investment, even if that means paying more taxes later.