Investing can feel like a steep learning curve. In addition to having a clear grasp of types of investment vehicles available and understanding the role investments play in overall financial strategy, it’s a good idea to understand how taxes may affect your investments. Knowing tax implications of various investment vehicles and investment decisions can help an investor tailor their strategy and end up with fewer headaches at tax time.
What Is Investment Income?
Tax requirements for investments can be complicated, and it can be helpful for investors to work with a professional to see how taxes might impact a return on their investment. Doing so might also help ensure that investors aren’t overlooking anything as they explore avenues for favorable tax treatments.
That said, it’s always helpful to enter into any discussion with some solid background information on when and how investments are taxed. Typically, investments are taxed at one or more of these three times:
When you sell an asset for a profit. This profit is called capital gains—the difference between what you bought an investment for and what you sold it for. Capital gains taxes are typically only triggered when you sell an asset; otherwise, any gain is an “unrealized gain” and is not taxed.
When you receive money from your investments. This may be in the form of dividends or interest.
When all profits from investments are considered under an umbrella. This view may trigger a tax called the Net Investment Income Tax (NIIT).
In the following sections, we delve deeper into each of these situations that can lead to taxes on investments.
Tax Rules for Different Investment Income Types
Capital Gains Taxes on Assets Sold
Capital gains are the profits an investor makes from the purchase price to the sale price of an asset. Capital gains taxes are triggered when an asset is sold (or in the case of qualified dividends, which is explained further in the next section). Any growth or loss before a sale is called an unrealized gain or loss, and is not taxed.
The opposite of a capital gain is a capital loss. This occurs when an investor sells an asset at a lower price than purchased. Why would an investor trigger a capital loss? That depends on the investor. Sometimes, an investor needs to sell an asset at a suboptimal time because they need the cash.
At other times, an investor may sell “losing” assets at the same time they sell assets that have gained as a way to minimize their overall tax bill, by using a strategy called tax-loss harvesting. This strategy allows investors to “balance” any gains by deliberately selling profits at a loss, which, according to IRS rules, can be carried over through subsequent tax years.
There are two types of capital gains, depending on how long you have held an asset:
• Short-term capital gains. This is a tax on assets held less than a year, taxed at the investor’s ordinary income tax rate.
• Long-term capital gains. This is a tax on assets held longer than a year, taxed at the capital-gains tax rate. This rate is lower than ordinary income tax. For 2021, as per the IRS , the long-term capital gains tax was $0 for individuals with taxable income less than $80,0000 and no more than 15% for most individuals (for those making more than $496,600, the rate jumps to 20%).
Dividend And Interest Taxes
Dividends are distributions that a corporation, S-corp, trust or other entity taxable as a corporation may pay to investors. Not all companies pay dividends, but those that do typically pay investors in cash, out of the corporation’s profits or earnings. In some cases, dividends are paid in stock or other assets.
Dividends that are part of tax-advantaged investment vehicles are not taxed. Generally, taxpayers will receive a form 1099-DIV from a corporation that paid dividends if they receive more than $10 in dividends over a tax year. All other dividends are either ordinary or qualified:
• Ordinary dividends are taxed at the investor’s income tax rate.
• Qualified dividends are taxed at the lower capital-gains rate.
In order for a dividend to be considered “qualified” and be taxed at the capital gains rate, an investor must have held the stock for more than 60 days in the 121-day period that begins 60 days before the ex-dividend date. (Additionally, said dividends must be paid by a U.S. corporation or qualified foreign corporation, and must be an ordinary dividend, as opposed to capital gains distributions or dividends from tax-exempt organizations.)
Both ordinary dividends and interest income on investments are taxed at the investors regular income rate. Interest may come from brokerage accounts, or assets such as mutual funds and bonds. There are exceptions to interest taxes based on type of asset. For example, municipal bonds may be exempt from taxes on interest if they come from the state in which you reside.
Total Investment Income and Net Investment Income Tax (NIIT)
Net investment income tax (NIIT) is a flat 3.8% surtax levied on investment income for taxpayers above a certain income threshold. The NIIT is also called the “Medicare tax” and, as per the IRS , applies to all investment income including, but not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, and income from businesses involved in trading of financial instruments or commodities.
In 2021, NIIT applies to individuals with an adjusted gross income (AGI) over $200,000 for single filers and $250,000 for married couples filing jointly. For taxpayers over the threshold, NIIT is applied to the lesser of the amount the taxpayer’s AGI exceeds the threshold or their total net investment income.
For example, consider a couple filing jointly who makes $200,000 in wages and has a NIIT of $60,000 across all investments in a single tax year. This brings their AGI to $260,000—$10,000 over the AGI threshold. This would mean the taxpayer would owe tax on $10,000. To calculate the exact amount of tax, the couple would take 3.8% of $10,000, or $380.
Cases of Investment Tax Exemption
Certain types of investments may be exempt from tax implications if the money is used for certain purposes. These investment vehicles are called “tax-sheltered” vehicles and apply to certain types of investments that are earmarked for certain uses, such as retirement or education.
There are two types of tax-sheltered accounts:
• Tax-deferred accounts. These are accounts in which money is contributed pre-tax and grows tax-free, but taxes are taken out when money is withdrawn. For example, a 401(k) retirement account grows tax-free until you withdraw money, at which point it is taxed.
• Tax-exempt accounts. These are accounts—such as a Roth 401(k) or Roth IRA, or a 529 plan—in which money can be taken out tax-free if the funds are taken out according to qualifications. For example, money in a Roth account is not taxed upon withdrawal in retirement.
Beyond investing in tax-sheltered accounts, investors may also choose to research or speak with a professional about tax-efficient investing strategies. These are ways to calibrate a portfolio that may help minimize tax hits, grow wealth, and ensure that key portfolio goals—such as ample savings for retirement or ensuring adequate liquidity —are met.
Dividends, interest, and gains can add up, which is why it’s important for a taxpayer to be mindful of investment taxes not only at tax time, but throughout the year. Understanding the implications of sales and keeping capital gains taxes in mind when planning sales can help investors make tax-smart decisions.
Because there are so many different rules regarding taxes, some investors find it helpful to work with a tax pro to ensure they’re not overlooking anything in their portfolio. Tax law also varies by state, and a tax pro should be able to tailor strategy to a taxpayer’s home state to minimize liability.
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