How are my investments taxed?
Investments are made with the hope they will generate income. This income is subject to federal and state income taxes, and the tax rate varies by the type of investment that creates the income.
In this article, I’ll explain the different tax rates and an easy way to avoid taxes on investments. At the end I’ll answer some common questions regarding taxes on investment income.
Income taxes
For federal income taxes, there are two different rates: ordinary and capital gains.
Ordinary income rates are applied to wages and self-employment income, as well as interest, ordinary dividends, and short-term capital gains. When you see the 10%, 12%, 22%, etc. tax brackets, you see ordinary income rates.
Capital gains rates are applied to qualified dividends and long-term capital gains. Capital gains rates are more favorable, with rates of 0%/15%/20%. The 0% capital gains bracket corresponds roughly to the 12% ordinary bracket, which applies to Married couples with gross income less than ~$120,000 (or Single people under ~$60,000).
There is an additional tax for middle- to high-income taxpayers, known as Net Investment Income Tax (NIIT). NIIT is a 3.8% surtax applied to all investment income, or the amount of income over a certain threshold (whichever number is smaller). For Married taxpayers filing jointly, the threshold is $250,000, for Single taxpayers, it is $200,000.
The state of Nebraska makes no distinction between ordinary and capital gains income. The top tax rate applied to all income is currently 5.84% and is scheduled to drop each year until 3.99% in 2027.
What can I do about taxes?
Retirement accounts
The easiest way to avoid (or defer) taxes is to hold investments inside a retirement account. If you are saving for retirement and can afford to not spend the money until at least age 59 ½, an IRA or 401(k) is a great place to buy investments.
Investments within tax-advantaged accounts (e.g. IRA, Roth IRA, 401k) are not taxed in the current year. Withdrawals from traditional retirement accounts will be taxed as ordinary income, while qualified withdrawals from Roth accounts are tax-free.
Let me repeat, investing in qualified retirement accounts is the best way to avoid or defer investment tax, and for many people, it is all you need to do.
Taxable accounts
If you are already contributing the maximum amount to your retirement accounts, or you have spending needs before age 59 ½, you may consider buying investments in a taxable brokerage account.
In this case, you can reduce taxes by limiting the frequency with which you buy and sell stocks. Taxes on capital gains and dividends are lower when you have held the stock for a requisite period. For capital gains, the period is one year; for dividends, the period is 60 days.
Don’t let the tax tail wag the investment dog
After comparing the taxation of investments, it’s natural to want more “capital gain” investments (with lower taxes) and less “ordinary” investments (with higher taxes). However, it’s important to note that ordinary investments are typically less risky than capital gain investments. Thus, paying higher ordinary income rates is sometimes necessary, as there are many benefits to holding at least some of your portfolio in safe investments.
It's important to be aware of taxes and to manage them wisely, but it’s more important to make sure your investments are appropriate for your situation.
FAQ
All my investments are in a retirement account. Do I pay taxes on interest and dividends?
No, but you might in the future.
Investments in a retirement account such as an IRA or 401(k) are tax deferred. In Traditional retirement accounts, the income will be taxed when you make withdrawals from the account. In Roth accounts, there are no taxes on qualified withdrawals (since you paid tax on the contribution to the account).
This is a benefit granted by the federal government, and the benefit is limited by annual contribution limits to these accounts.
Do I have to report interest, dividends, and capital gains on my tax return?
Yes. Unless your investments are in a retirement account, your custodian (the company who holds your investments) will send you a Form 1099 before mid-February. This document will summarize your taxable transactions for the year.
Those numbers will end up on your Form 1040 (the main tax return form) on lines 2 (interest), 3 (dividends), and 7 (net capital gain/loss).
I reinvest my dividends. Do I pay taxes on that amount?
Yes. If your investment is held outside of a retirement account, you will be taxed on interest and dividends in the year the income is received, even if you elect to reinvest dividends. If you have significant amounts of interest and dividends, you may consider increasing your tax withholding from your paycheck or making estimated tax payments to the IRS.
Do I pay taxes when I day trade?
Yes, and it’s not good.
As transaction costs have decreased, custodians like Robinhood have made it easy for average investors to buy and sell stocks with great frequency. When it goes well, it seems like easy money, but there is a tax bill to pay.
At the end of the year, your custodian will send you a Form 1099, which lists your transactions for the year. Your tax preparer will fill out Schedule D and calculate your net capital gain, which will be taxed.
If you are day trading, it’s likely most of your capital gains will be short-term, meaning they are taxed at the higher ordinary income rates. Additionally, any dividends you receive would likely not qualify for the lower tax rate.
Finally, if your day trading activity is “substantial” and “continuous”, you may be subject to special IRS rules, so please trade with caution.
Can I use life insurance and annuities to avoid taxes?
Most whole-life insurance and annuity contracts feature tax-deferral, in which the income generated by your policy is not taxed until your remove it from the contract. Some unscrupulous salesmen highlight this feature to deter people from investing outside of retirement accounts. There are some downsides to this strategy:
Life insurance and annuities come with fees that often exceed the potential tax savings. Even worse is the products that claim to have no fees; with these products, you can bet the insurer is earning money by giving you a smaller payout.
These contracts often have surrender charges, in which the insurer will penalize you if you withdraw – “surrender” – your money within a set period, often seven years.
These products are taxed at higher rates. Qualified dividends and long-term capital gains are taxed at favorable capital gains rates. Income from a life insurance or annuity contract is taxed at higher ordinary income rates.
About the Author
Joseph Fowler, CFP® is a financial planner and co-owner of 402 Financial in Lincoln, NE.
402 Financial provides financial planning and investment management services to people approaching or in retirement. Joe always acts as a fiduciary and never takes commissions on product sales.
Click this link to schedule a free consultation with Joe.
