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Key takeaways
- You pay taxes on investment profits when you sell an investment or receive an interest or dividend payment
- If you hold an investment for at least a year, you’ll pay taxes at a lower rate
- Accounts like a 401(k)s or an IRA can help reduce your investment taxes
Every April, Americans file their tax returns and settle their bill with the IRS. Taxes can have a significant impact on your investment portfolio and its performance. Understanding how the IRS taxes investments and how to limit those taxes is an integral part of any investing strategy.
Here’s what investors need to know to reduce their tax bill.
How are stocks, mutual funds and ETFs taxed?
When you invest in stocks, mutual funds or ETFs, you typically earn a return in two ways. These include selling your investment for a profit and receiving dividends. These investment profits get treated differently at tax time.
Capital gains taxes
When you buy an investment like a stock or mutual fund, your broker will note the price you paid for that security. The price you pay is the cost basis for your investment.
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When you sell an investment, you compare the sale price to your cost basis. If you sell for a profit, you earn a capital gain. If you sell at a loss, you have a capital loss.
At the end of the year, you must pay taxes on your overall capital gains. For example, if you earned a $10,000 capital gain on one stock and had a $5,000 capital loss on a different investment, you’ll only pay taxes on the net profit of $5,000.
Capital gains are further broken down into long-term and short-term capital gains. You receive short-term gains on investments held for less than one year and long-term gains on investments held for a year or longer.
Income tax on short-term gains is paid as though those gains were regular income. Otherwise, you pay a lower tax rate on long-term gains.
The tax rates for a single filer for 2022 are:
Short-term capital gains tax rates
$0 – $10,275
10%
$10,276 – $41,775
12%
$41,776 – $89,075
22%
$89,076 – $170,050
24%
$170,051 – $215,950
32%
$215,951 – $539,900
35%
$539,001+
37%
Long-term capital gains tax rate
$0 – $41,675
0%
$41,676 – $459,750
15%
$459,751+
20%
Taxes on dividends
There are two categories of dividends to consider, including qualified and nonqualified.
By default, all dividends are unqualified. The exception is if the dividend is paid by a U.S. corporation or qualifying foreign company and you’ve held your shares in the company for at least 60 days during the 121 days starting 60 days before the ex-dividend date.
The IRS taxes nonqualified dividends as regular income. If you have qualified dividends, these are taxed at the long-term capital gains tax rate.
Reducing your taxes on stocks, mutual funds and ETFs
One of the nice things about stocks is that you only pay capital gains taxes when you sell your investment. Some mutual funds make annual capital gains distributions, but you can still limit your tax bill by holding on to your shares.
You can reduce your capital gains taxes simply by holding investments for longer periods. If you don’t sell, you won’t owe taxes. You might also consider tax-loss harvesting, which involves strategically selling poor-performing investments for a loss to reduce your overall gains.
Limiting taxes on dividends can be more difficult. One effective strategy is to hold dividend-paying investments in tax-advantaged accounts like a 401(k) or an IRA so that you don’t have to pay income taxes.
How are bonds taxed?
Bond taxes depend largely on the issuer of the bond and how you profit from the investment.
You can buy and sell some bonds on the open market just like you can do with stocks and other securities. If you make a capital gain on a bond investment, you’ll pay capital gains taxes.
However, most people earn a return from bonds via interest payments. Any interest received from a bond gets treated as taxable income.
Some special bonds are exempt from certain taxes. For example, municipal bonds issued by state or local governments are typically tax-free at the federal level. Some states also exempt income from municipal bonds from state income taxes.
The IRS does tax income from bonds issued by the federal government, but they are generally exempt from state and local income taxes.
Reducing taxes on bonds
Bonds are generally tax-inefficient because your interest payments are treated as regular income.
The best way to reduce taxes on bonds is to hold the bonds in a tax-advantaged investment account. If you must hold bonds in a taxable account, you may want to consider municipal bonds or federal government bonds that are exempt from certain taxes.
How are options taxed?
The vast majority of basic options trades generate short-term gains and losses. This means that you’ll pay tax on your overall profits at your regular income tax rate.
There are some exceptions to this rule. For example, options with expiration dates more than a year in the future may generate long-term gains or losses. Tax treatment of more complex strategies, such as covered calls, straddles or prospective puts, can get complicated.
If you plan to use these high-level options trading strategies, consult a tax professional or your broker for advice on how the IRS will tax your trades.
The bottom line
Nobody likes paying taxes, but they can’t be avoided. Understanding how they impact your investments is an important part of maximizing your investment portfolio.
To reduce investment taxes, consider using tax-advantaged accounts like a 401(k) or an IRA for your least tax-efficient investments, like dividend-paying stocks and hold your investments for at least a year before selling.
If you need a hand creating a tax-efficient portfolio, consider working with Q.ai. Its artificial intelligence can help build a portfolio for almost any goal and economic climate. With its Investment Kits, investing can be easy and fun.
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