Investing is a big step you can take as part of your financial plan. Understanding a few key concepts around taxes and investing can help you avoid unexpected tax payments and make more informed decisions about managing your investments.
Take quiz: Which investment account is right for you?
Types of investment income taxes
Capital gains tax
Capital gains taxes apply when you sell investments for a profit. The tax rate depends on how long you've held the investment (separated into short-term and long-term) and your total taxable income. You can find the capital gains tax rates on the IRS website.
Short-term capital gains (i.e., from assets held for one year or less) are taxed as ordinary income, while long-term gains (i.e. from assets held for more than a year) are generally taxed at a lower rate.
Dividend income tax
Dividend income is taxed depending on whether it's qualified or ordinary. Qualified dividends are taxed at the long-term capital gains rate, while ordinary dividends are taxed as ordinary income.
The IRS requires the corporation paying the dividends to identify whether a payment is considered ordinary or qualified, so this isn’t something you’ll typically need to figure out on your own.
Interest income taxes
Interest income from investments like bonds is generally taxed as ordinary income. In other words, it’s taxed the same as your wages. Remember this when considering investments that generate interest income.
Real estate tax
Real estate investments have unique tax implications. Rental income is taxable, but you can deduct expenses like mortgage interest and property taxes.
Also, when you sell a rental property, you'll face capital gains taxes on the profit.
4 strategies that may help minimize investment taxes
Here are four tax-optimizing strategies to consider:
1. Prioritizing tax-advantaged accounts
Tax-advantaged accounts have the potential to reduce your tax liability. We'll list a few types of tax-advantaged accounts. Note that each has its own individual rules and limits, so be sure you understand those before taking any actions.
401(k): Contributions to a traditional 401(k) are pre-tax (meaning you pay taxes on it later, generally at distribution) and can reduce your taxable income for the year. Contributions to a Roth 401(k) are post-tax (meaning you pay the tax up front when contributing), allowing for potential tax benefits if future distributions qualify under current IRS rules
Traditional Individual Retirement Accounts (IRAs): Traditional IRAs let you make tax-deductible contributions. This means you don't pay taxes on your contributions (up to a certain limit, depending on your income and filing status) and instead pay when you make withdrawals.
Roth IRAs: Contributions to a Roth IRA are post-tax, meaning the taxes are paid up front when contributing. This allows for potential tax benefits for future distributions, if they qualify under the current IRS rules
Health Savings Accounts (HSAs): Contributions, earnings and distributions for qualified expenses aren't taxed
529 College Savings Plans: Any investment growth would be tax-deferred, and withdrawals for qualified education expenses are tax-free
Read more: Roth IRAs vs. traditional IRAs
2. Using tax-efficient investing strategies
Tax-efficient investing strategies can help reduce a potential tax bill. For example, some investors will choose mutual funds and exchange-traded funds (ETFs) because these securities tend to have fewer taxable events happen during a given year.
Additionally, placing high-yield investments in tax-advantaged accounts might help shield you from higher tax rates. A tax professional can help you tailor a strategy to your specific circumstances.
Some investors will choose mutual funds and exchange-traded funds (ETFs) because these securities tend to have fewer taxable events happen during a given year.
3. Implementing tax-loss harvesting … or working with someone who can help you implement it
Tax-loss harvesting is essentially when an investor sells certain securities at a loss to offset capital gains from other investments and reduce their overall tax bill. However, it’s crucial to be aware of the IRS' "wash sale rule," which prohibits buying a substantially identical investment within 30 days before or after selling a loss. Consider working with a tax professional, if you’re curious about how to implement tax-loss harvesting.
4. Understanding holding periods
An investment holding period — how long you have the investment before selling it — can have a huge impact on its tax treatment. So, it’s critical that you understand capital gains taxes when considering different investments. Generally, holding investments for more than one year can qualify you for lower long-term capital gains tax rates.
Key tax deadlines
Stay aware of key tax dates to keep on top of things. Individual firms and brokerages may also have their own deadlines for processing and sending necessary documentation out to investors.
December 31: Deadline for 401(k) contributions and tax-loss harvesting
Tax filing deadline (usually April 15): Deadline for IRA and HSA contributions
Proper planning for fewer tax surprises
By understanding these concepts and strategies, you can better manage your investment taxes. To understand how taxes affect your situation, talk to a tax expert, who can personalize these strategies for you.
