While taxes may be unavoidable, understanding how they work can help you minimize them, or at least help you get the most bang for your buck. You’re probably already pretty familiar with sales tax and taxes on your salary, so let’s review what you need to know about how taxes apply to your investment returns.

Capital gains.

Capital gains taxes are one of two basic types of taxes on investment returns. You’ll pay capital gains taxes when you make a profit from selling an asset such as a stock, bond or even a house. There are two types of capital gains:

  • Short-term capital gains: Earnings on assets held less than one year are considered short-term capital gains and are treated the same as ordinary income. Like your income, short-term capital gains are taxed at the marginal tax rate, which corresponds to your tax bracket for the year. The more you make, the higher your marginal tax rate is. Short-term capital gains taxes are usually higher than other tax rates (generally greater than 15% in 2017, depending on your income level).
  • Long-term capital gains: If you hold your assets for more than one year, long-term capital gains taxes apply to any profits you make when you sell. These gains are taxed at a lower rate than short-term capital gains (usually 0% or 15% in 2017, depending on your income level).1

Keep in mind that capital gains don’t apply to investment income in retirement plans. Distributions you take from a 401(k) or traditional IRA are taxed as regular income, and aren’t subject to capital gains.

Dividends and income.

Taxes on capital gains are not the only taxes investors face. Dividends and income are also taxed.

  • Qualified dividends: If you’re invested in stocks, you may receive dividend payments. A qualified dividend is a dividend payment you receive on stocks you’ve owned for a specific holding period (usually at least 60 days). These are generally taxed at the more advantageous long-term capital gains rate. Dividend payments that don’t meet the holding period requirement are considered “unqualified,” and are taxed at your marginal rate.
  • Interest income: Interest income includes payments from bonds and the money you earn from interest-bearing accounts, such as a money market account. Like short-term capital gains, interest income is taxed at the higher marginal tax rate.

Special considerations for capital gains.

While you may not like paying taxes on your investment earnings, keep in mind that it’s a two-way street: While the government shares in your profits, it also shares in your losses. Say that one year you had $5,000 in gains in one investment, but also had losses of $10,000 in another. This puts you $5,000 in the hole. You can currently declare up to $3,000 each year in capital losses to reduce your taxable income for the year. Losses greater than that (so, the remaining $2,000 in our example) can carry over to the next year.2

The government also offers a special capital gains exclusion when you sell your main home. This allows you to exclude up to $250,000 in capital gains from the sale if you’re single, or up to $500,000 if you’re married (note that these figures are for 2017 and could potentially change). There are some additional considerations, however. First, you have to pass the “ownership and use” test to show that the property was your primary residence. To pass, you must have owned and lived in the house for at least two of the past five years. You also can’t have excluded gains from the sale of a different home within the previous two years.3 The rules around this and other capital loss write-offs are detailed, so read up and be clear on what you can and can’t do before moving forward.

Tax rates on investment returns can have a big impact on your bottom line, so it’s important to understand how the timing of selling your assets can affect your tax liability. Make sure you understand the tax implications before you make a move. After all, the less money you fork over to the government, the more you’ll get to keep for yourself.

 

This post is based on Chapter 11 from the book, The Intelligent Portfolio, by Christopher Jones, Financial Engines’ chief investment officer. The content has been revised for the purposes of this blog.
The information provided is general in nature, is for informational purposes only, and should not be construed as legal or tax advice. Financial Engines does not provide legal or tax advice. Financial Engines cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws which may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Financial Engines makes no warranties with regard to such information or results obtained by its use. Financial Engines disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.
1 Backman, M. (March 21, 2017). Short-Term Capital Gains Tax Rates in 2017. The Motley Fool. Retrieved August 3, 2017, from https://www.fool.com/retirement/2017/03/21/short-term-capital-gains-tax-rates-in-2017.aspx
2 How Long Do Capital Gains and Losses Carry Forward? The Motley Fool. Retrieved August 3, 2017, from https://www.fool.com/knowledge-center/how-long-do-capital-gains-loss-carry-forward.aspx
3 Topic 702 – Sale of Your Home. Internal Revenue Service. Retrieved August 3, 2017, from https://www.irs.gov/taxtopics/tc701.html
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