How are different types of investments taxed?

Location, Location!
The British Virgin Islands are home to fantastic beaches and lots of U.S. investment income.
The British Virgin Islands are home to fantastic beaches and lots of U.S. investment income.
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When figuring out how investments are taxed, location matters. If you open a bank account in a tax-free spot like the British Virgin Islands, you can funnel your investment income there, and it won't be subject to U.S. taxes. Corporations like to use similar tricks — that's why there's a five-story office building in the Cayman Islands that is the registered headquarters for no fewer than 18,857 different companies!

According to 2010 tax records, U.S. companies made $129 billion in Bermuda, the Cayman Islands and the British Virgin Islands. That's $873,611 per person who lives there [source: Norris]!

In 2010, Congress enacted FATCA, or the Foreign Account Tax Compliance Act, in an effort to crack down on investors dodging taxes with overseas accounts. FATCA requires financial institutions in other countries to tell the IRS about any accounts over $50,000 held by U.S. citizens [source: IRS].

The jury is still out as to whether FATCA will be as effective as it wants to be, but here's one thing you don't need to worry about: double-taxation. The IRS doesn't expect you to pay up in two countries. As an example, if you have investment income in Germany and can show that you paid what you owed there, you'll get something called a foreign tax credit, which should significantly reduce the amount you owe at home.

But the taxes you owe don't just depend on where your investments are overseas; it also matters what kind of account they're in here at home. After-tax income from investments is called "tax efficiency." From the point of view of tax efficiency, there are three different types of accounts: taxable, tax-deferred and tax-exempt.

Income earned from a brokerage account, for instance, is usually taxed as capital gains. With a tax-deferred account like an IRA or a 401(k), you can hold off on paying annual taxes until you withdraw the funds. Finally, there are tax-exempt accounts like Roth IRAs and Roth 401(k)s that allow you to invest after-tax income tax-free.

So what are the taxes on that investment in pee-powered mobile phones? Well, since the Bill & Melinda Gates Foundation is officially tax-exempt, and since we're taxed only on the money we make from our investments, and since those phones are intended to help impoverished people living in remote areas of the developing world — let's just say the question doesn't have a pot to pee in.

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