What You Need to Know about Investment Taxes

By Eric Tyson

When you invest outside tax-sheltered retirement accounts, the profits and distributions on your money are subject to taxation. (Distributions are taxed in the year that they are paid out; appreciation is taxed only when you sell an investment at a profit.) So the non-retirement-account investments that make sense for you depend (at least partly) on your tax situation.

Tracking taxation of investment distributions

The distributions that various investments pay out and the profits that you may make are often taxable, but in some cases, they’re not. It’s important to remember that it’s not what you make pretax on an investment that matters, but what you get to keep after taxes.

Interest you receive from bank accounts and corporate bonds is generally taxable. U.S. Treasury bonds, which are issued by the U.S. federal government, pay interest that’s state-tax-free but federally taxable.

Municipal bonds, which state and local governments issue, pay interest that’s federally tax-free and also state-tax-free to residents in the state where the bond is issued. (For more on bonds, see Book 4.)

Taxation on your capital gains, which is the profit (sales price minus purchase price) on an investment, is computed under a unique system. Investments held less than one year generate short-term capital gains, which are taxed at your normal marginal income tax rate.

Profits from investments that you hold longer than 12 months are long-term capital gains. Under current tax law, these long-term gains are taxed at a maximum 20 percent rate, except for folks in the two lowest income tax brackets: 10 percent and 15 percent. For these folks, the long-term capital gains tax rate is 0 percent (as in nothing).

Dividends paid out on stock are also taxed at the same favorable long-term capital gains tax rates under current tax law.

The Patient Protection and Affordable Care Act (informally referred to as Obamacare) increased the tax rate on the net investment income for taxpayers with adjusted gross income above $200,000 (single return) or $250,000 (joint return). Net investment income includes interest, dividends, and capital gains. The increased tax rate is 3.8 percent.

Determining your tax bracket

Many folks don’t realize it, but the federal government (like most state governments) charges you different income tax rates for different parts of your annual income. You pay less tax on the first dollars of your earnings and more tax on the last dollars of your earnings.

Your federal marginal income tax rate is the rate of tax that you pay on your last, or so-called highest, dollars of income. Your taxable income is the income that is left after taking allowed deductions on your return.

Your actual marginal tax rate includes state income taxes if your state levies an income tax.

There’s value in knowing your marginal tax rate. This knowledge allows you to determine the following (among other things):

  • How much you could reduce your taxes if you contribute more money to retirement accounts
  • How much you would pay in additional taxes on extra income you could earn from working more
  • How much you could reduce your taxable income if you use investments that produce tax-free income

Devising tax-reduction strategies

Use these strategies to reduce the taxes you pay on investments that are exposed to taxation:

  • Make use of retirement accounts and health savings accounts. Most contributions to retirement accounts gain you an immediate tax break, and once they’re inside the account, investment returns are sheltered from taxation, generally until withdrawal.

    Similar to retirement accounts are health savings accounts (HSAs). With HSAs, you get a tax break on your contributions up-front; investment earnings compound without taxation over time; and there’s no tax on withdrawal so long as the money is used to pay for health-related expenses (as delineated by the IRS).

  • Consider tax-free money market funds and tax-free bond funds. Tax-free investments yield less than comparable investments that produce taxable earnings, but because of the tax differences, the earnings from tax-free investments can end up being greater than what taxable investments leave you with. If you’re in a high-enough tax bracket, you may find that you come out ahead with tax-free investments.

For a proper comparison, subtract what you’ll pay in federal and state taxes from the taxable investment to see which investment nets you more.

  • Invest in tax-friendly stock funds. Mutual funds that tend to trade less tend to produce lower capital gains distributions. For mutual funds held outside tax-sheltered retirement accounts, this reduced trading effectively increases an investor’s total rate of return. Index funds are mutual funds that invest in a relatively static portfolio of securities, such as stocks and bonds. (This is also true of some exchange-traded funds.) They don’t attempt to beat the market; rather, they invest in the securities to mirror or match the performance of an underlying index. Although index funds can’t beat the market, the typical actively managed fund doesn’t, either, and index funds have several advantages over actively managed funds.
  • Invest in small business and real estate. The growth in value of business and real estate assets isn’t taxed until you sell the asset. Even then, with investment real estate, you often can roll over the gain into another property as long as you comply with tax laws. Increases in value in small businesses can qualify for the more favorable longer-term capital gains tax rate and potentially for other tax breaks. However, the current income that small business and real estate assets produce is taxed as ordinary income.

Short-term capital gains (investments held one year or less) are taxed at your ordinary income tax rate. This fact is another reason why you shouldn’t trade your investments quickly (within 12 months).