Taxes may be an inevitable part of making money. Whether your income is from wages or investments, taxes typically consume a portion. And taxes impact investments in different ways. There are different rates applied to different types of returns. Some investments can create taxable income indirectly. But investment accounts may provide temporary shelter from current taxation. That’s why planning is so important.
How are Different Investment Returns Taxed?
Investments typically generate only two types of returns – income and capital gains. Income results from holding an investment. Capital gains result from selling an investment.
Stocks and bonds (whether held directly or in a mutual fund) can generate both types of returns. Investment income is created by dividends on stocks and interest on bonds. When a stock or bond is sold, it may also generate a capital gain.
Typically investment income is taxed at the same rate as ordinary income, based on how much money you make. But some dividend income may be taxed at a lower rate.
Dividends on stocks held over a set period of time qualify for preferential tax treatment. These “qualified dividends” typically get taxed at the same rate that applies to net capital gains. Capital gains rates are determined by the length of time you hold an investment before selling.
There are two capital gains rates:
1) Short-term – applies to investments sold within a year of purchase
2) Long-term – applies to investments sold after one year
For tax year 2023, the rate for most individuals on net capital gains is no higher than 15 percent. Some or all net capital gain may be taxed at zero percent depending on the nature of the gain and your income.[1]
The Mutual Fund Exception
While capital gains are triggered by selling an investment, those sales don’t have to be direct. In other words, you don’t have to be the one selling. As an example, consider the mutual funds you own.
You have an indirect ownership interest in the securities in those funds. So, you also own a portion of any gains created when a fund manager sells assets.
Mutual funds regularly make capital gains distributions to shareholders. Those capital gains may be taxable to you unless they are held in certain types of accounts.
Some Investment Accounts are Sheltered From Current Taxation
Some investment accounts can shelter your returns from current taxes for many years. Traditional IRAs, Roth IRAs, and 529 College Savings Plan accounts let you defer taxes on income and capital gains.
Returns earned in a Traditional IRA are not taxed until funds are withdrawn from the account. Those withdrawals are taxed as ordinary income. That means all previous income and gains in the account ultimately get taxed at the same rate.
Qualified distributions from a Roth IRA are never taxed. But they enjoy the same tax deferral as a Traditional IRA.
Similar treatment applies to 529 accounts. Withdrawals made to pay qualified education expenses aren’t taxed.
So, using these types of tax deferred accounts may help you increase the tax efficiency of your overall portfolio.
How Important is Tax Planning?
Careful planning is the key to making your investment accounts more tax efficient. But more important than the tax implications of your investments is that the pieces fit your unique consumption goals, investment objectives, and financial circumstances.
Avoiding taxes at the expense of investment return may not be an optimal approach. Working with a qualified tax advisor (like a CPA) may be a good first step to make sure everything comes together efficiently given your specific circumstance.
1 There are a few exceptions where capital gains may be taxed at rates greater than 20%. Gains from selling section 1202 qualified small business stock may be taxed as high as 28%. Net capital gains from selling collectibles are taxed at a maximum 28% rate. And unrecaptured section 1250 gain from selling section 1250 real property is taxed at a maximum 25% rate.
