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Breaking Down Investment Taxes

Zoe Team

Apr 18, 2022

5 min read

A financial advisor reviewing a plan with two clients at a table

Key Takeaways

Investment taxes shouldn’t drive strategy but need consideration.
Capital gains rates vary based on your holding period.
Tax-advantaged accounts can optimize your long-term returns.

Frequently Asked Questions

Should taxes dictate my investment strategy?

No; strategy should focus on your long-term goals. However, understanding taxes helps minimize drag on your net returns.

What is the difference between short and long-term gains?

Short-term gains are taxed at ordinary income rates, while long-term gains held over a year benefit from lower, preferential capital gains tax rates.

How can I reduce my investment tax burden?

Utilize tax-advantaged accounts like IRAs or 401(k)s and consider tax-loss harvesting to offset gains with investment losses.

Investment taxes should not be the determining factor in your investment strategy, but understanding them will be helpful come tax time!

There is nothing quite as awful as a bad surprise. Be it an emergency, taxes, or a rate increase - why is it that unpleasant surprises are usually costly? Often, the blame can be placed on a lack of clarity and timely planning.

Lately, we’ve heard from investors that this tax season has been “extra frustrating.” For those who are feeling the burn of costly taxes due to their investments, the best way to avoid future sticker shock is to prepare. The first step towards decreasing taxes is to be aware of where those costs originate. That’s where investment tax rates come into play: while tax rates should not be the determining factor in your investment strategy, understanding them can help to know what you’ll be dealing with come tax time!

Investment tax rates are the taxes you will owe on income from your investments. The federal government taxes both investment income (dividends, interest, and rent), as well as capital gains. There are two main types of tax rates associated with these taxes: preferential rates and ordinary income rates.

Preferential rates mean the money being taxed has a preferred source, holding period, or purpose according to the IRS. Long-term capital gains and qualified dividends are taxed at preferential rates of either 0%, 15%, or 20%. In addition, you could potentially owe a 3.8% surtax on net investment income. You’ll only owe the surtax if your investment income and your modified adjusted gross income go over a certain amount.

Ordinary income rates, on the other hand, are the normal rate at which most income is taxed. In addition to wages, your short-term capital gains, interest, and non-qualified dividends are subject to ordinary income tax. Finally, you could be subject to the alternative minimum tax (AMT). This is triggered when taxpayers have more income than an exemption amount and they make use of many common itemized deductions.

When Do These Different Investment Tax Rates Come Into Play?

As discussed above, investment taxes can occur upon the sale of a position, as well as from ongoing dividends, interest, or fund distributions. Here is how these tax rates come into play depending on the type of income gained from your investment.

Capital Gain Taxes

When you sell a capital asset (like a stock, bond, or investment property) the sale price minus what you paid for it will equal the gain or loss. Whether the position is taxed at ordinary income (short term rates) or preferential rates (long term rates) will depend on how long you held the asset.

If your asset is held for less than one year, then it is short-term. Keep in mind that if your asset is held for one year or longer then it will be taxed at long-term rates.

Dividends

A dividend is a piece of a company’s profits paid to shareholders. For tax purposes, there are two kinds of dividends: qualified or nonqualified.

Qualified dividends are given the benefit of preferential tax rates. The IRS has certain requirements to be considered ‘qualified’ but don’t worry your investment custodian will tell you if you qualify. If your dividend does not match these terms then it is nonqualified and taxed at ordinary income rates.

Interest

Most interest income earned on investments is taxable as income at both the federal and state level. This includes the interest you earn from: CDs, US savings and treasury bonds, corporate bonds, checking and savings accounts, money market accounts, and interest income from pass-through businesses.

The main exception for tax-exempt interest is on municipal bonds. The interest is exempt from federal taxes but may not be exempt from state and local taxes depending on the municipality

Mutual Fund and ETF Distributions

Mutual funds and ETFs pay out distributions to all of their shareholders. As a reminder, mutual funds and ETFs are both investment products that have underlying stocks, bonds, and/or commodities.

When there is trading within the fund, it will create capital gains which then have to be paid out to the shareholders. These distributions are taxable to you even though you haven’t made any changes. The good news is that if you are automatically reinvesting, these distributions will be added to your cost basis so they will not be taxed twice.

Preempt a Bad Surprise: Investment Tax Strategy Next Steps

After reading about how various tax rates come into play, you may be thinking, “knowledge is power, but now what?”

While the rates your investments may be taxed under shouldn’t be deciding factor in how you might invest, having a baseline understanding can help you steer clear of unpleasant surprises. The next step is to begin developing a tax strategy. Tax planning analyzes your finances, assets, and liabilities to determine where you might optimize your taxes in the short and long term. As you’re likely realizing, there are plenty of variables that come into play!

From implementing a robust tax-loss harvesting strategy to introducing charitable tax distributions or evaluating tax credits you may not be considering currently, the best way to integrate tax-efficient strategies alongside your investment strategy is by speaking to an expert.

Investment taxes should not be the determining factor in your investment strategy, but understanding them will be helpful come tax time!

When Do These Different Investment Tax Rates Come Into Play?

Capital Gain Taxes

If your asset is held for less than one year, then it is short-term. Keep in mind that if your asset is held for one year or longer then it will be taxed at long-term rates.

Dividends

A dividend is a piece of a company’s profits paid to shareholders. For tax purposes, there are two kinds of dividends: qualified or nonqualified.

Interest

The main exception for tax-exempt interest is on municipal bonds. The interest is exempt from federal taxes but may not be exempt from state and local taxes depending on the municipality

Mutual Fund and ETF Distributions

Mutual funds and ETFs pay out distributions to all of their shareholders. As a reminder, mutual funds and ETFs are both investment products that have underlying stocks, bonds, and/or commodities.

Preempt a Bad Surprise: Investment Tax Strategy Next Steps

After reading about how various tax rates come into play, you may be thinking, “knowledge is power, but now what?”

Disclosures: Zoe Financial, Inc. ("Zoe Financial") is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. Zoe Financial provides investment advisory services and access to independent registered investment advisers through its platform. The information provided by Zoe Financial is for educational and informational purposes only and should not be construed as personalized investment advice or as an offer to buy or sell any security. All investments involve risk, including possible loss of principal. Past performance is not indicative of future results. Clients should consult with their own financial, tax, or legal professionals before making any investment decisions. The material presented by Zoe Financial is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy, or investment product. Material presented has been gathered from sources believed to be reliable, however Adviser cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Past performance is no guarantee of future results. Zoe Financial does not provide legal or tax advice, and nothing contained in these materials should be taken as legal or tax advice. SEC Registration does not constitute an endorsement of Zoe Financial by the SEC nor does it indicate that Zoe Financial has attained a particular level of skill or ability. The sole purpose of this material is to inform, and it in no way is intended to be an offer or solicitation to purchase or sell any security, other investment or service, or to attract any funds or deposits. Investments mentioned may not be appropriate for all clients. Before making any investment, each investor should carefully consider the risks associated with the investment, as discussed in the applicable offering memorandum, and make a determination based upon their own particular circumstances, that the investment is consistent with their investment objectives and risk tolerance. Lower expenses do not guarantee better investment performance. Certain information contained herein may constitute forward-looking statements. Due to various risks and uncertainties, actual events, results or the performance of a fund may differ materially from those reflected or contemplated in such forward-looking statements.

Disclosure: This page is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accounting, tax, legal or financial advisors. The observations of industry trends should not be read as recommendations for stocks or sectors.

Investment advisory services are provided by Zoe Financial, Inc. (Zoe Financial), an investment adviser registered with the U.S. Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training. Learn more about Zoe Financial on the SEC’s Investment Adviser Public Disclosure website. Brokerage services are provided by Zoe Securities LLC and Apex Clearing Corporation, members of the Financial Industry Regulatory Authority Inc. (FINRA) and Securities Investor Protection Corporation (SIPC). Learn more about Zoe Securities and Apex on FINRA’s BrokerCheck website.

The information in the visuals above is for illustrative purposes only and does not represent an actual user's account, balance, or return. Zoe Financial does not provide tax or legal advice.

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