How are Investments Taxed (and How Can I Minimize Them)?

How are Investments Taxed (and How Can I Minimize Them)?

While many people tend to focus on how much money their investments will produce for them, it can be equally as important to understand how the IRS will tax this income. In this post, we’ll explore the tax treatments on interest, capital gains, and dividends, and then discuss how you can use this knowledge to your advantage.

Interest

Most forms of interest are considered to be taxable in the same way as money you would have earned from your employer (also known as ordinary income). Examples would be interest earned on savings accounts, money market accounts, CDs, etc.

If you’ve got treasury bills, notes, or bonds, then you will also owe ordinary income taxes at the federal level, but they would be exempt from state and local taxes. Alternatively, the interest on municipal bonds is tax-exempt at the federal level, but you will be taxed at the state level.

If you’ve got any U.S. savings bonds (series EE or I), the interest you’d receive is also taxable at the federal level. However, you only need to declare it at the time of redemption.

Capital Gains

Anytime you sell an asset such as a stock, bond, or piece of real estate for more than you bought it for, this is called a capital gain. According to the IRS, capital gains are classified and taxed in one of two ways:

Short-Term Capital Gains

Short-term capital gains are assets owned for one year or less. An example of this would be a stock you purchased and then sold six months later. These types of assets are treated just like ordinary income and receive no special tax benefits.

Long-Term Capital Gains

Long-term capital gains are assets owned for more than one year. An example of this would be a stock you purchased and then sold five years later. These types of assets classically receive better tax treatment than short-term capital gains or ordinary income.

Capital Losses

Just like with gains, you can also declare capital losses if you sold any assets for less than what you paid for them. Losses can be combined with your gains to offset your “net capital gain” which is actually the amount you will be taxed on.

Dividends

Dividends are when a company or mutual fund pays out a portion of its profits to the shareholders. According to the IRS, dividends are classified and taxed in one of two ways:

Qualified Dividends

Qualified dividends are the payments you received from assets that have been held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. More on how this works in this article here. Once they meet this requirement, this income will receive preferential tax treatment.

Non-qualified Dividends

Non-qualified dividends are usually those payments that don’t meet the requirements to be considered qualified dividends. However, they can also include other types of dividends such as those from employee stock options and real estate investment trusts. Just as the name implies, non-qualified dividends will not receive special tax treatment and will be taxed as ordinary income.

Taxes on Long-Term Capital Gains and Qualified Dividends

When we say that long-term capital gains and qualified dividends receive preferential tax treatment, what we mean is that this income is taxed according to a lower, alternate tax bracket system which will result in a reduced amount of money owed to the IRS.

Depending on your adjusted gross income and filing status, you will pay the following taxes based on the earnings you receive according to these brackets for 2021:

  • 0% on $0 – $40,400 for individual filers and $0 – $80,800 and married filing joint
  • 15% on $40,400 – $445,850 for individual filers and $80,800 – $501,600 and married filing joint
  • 20% on $445,850 or more for individual filers and $501,600 or more and married filing joint

Using Capital Gains and Dividends to Minimize Your Taxes

Whenever possible, the best way to minimize your taxes for any earned interest, capital gains, or dividends is to hold these assets in tax-advantaged retirement accounts like a 401k, IRA, etc. This is useful because anytime you receive a payment or make a trade, you will not owe any taxes until the money is withdrawn.
If for any reason you need to hold money outside of your retirement accounts, perhaps because of RMDs or if you are no longer able to contribute to your retirement accounts, then it will be preferred to invest in assets that will meet the requirements to become long-term capital gains and qualified dividends.
For example, if your tax filing status is married filing jointly and you plan to withdraw $80,000 from your retirement funds, then the top marginal tax rate that you’d pay on this amount would be 12%. Alternatively, if you were invested in stocks through a taxable brokerage account and received this same $80,000 as long-term capital gains and qualified dividends, then it would fall into the 0% tax bracket and you would owe nothing.

Let a Professional Help You Lower Your Taxes

Tax laws can be complicated. There are many different ways to structure your investments so that you’ll owe as little to the IRS as possible. If you’d like to learn more about how your specific tax situation can be optimized, then please feel free to connect with us by sending an email or filling out our contact form.