Investing in stocks, bonds, mutual funds, exchange-traded funds and other investment vehicles is a sound part of a personal finance strategy. And a well-designed investment strategy can lead to income growth and financial success. But when you make money with investments, Uncle Sam comes knocking. Here's what you need to know about how investing money affects your taxes.
The Basics of Investment Taxes
When you invest money, it affects your taxes by generating income, gains and sometimes losses that can impact your tax liability (the total amount of tax you owe the government). Here's a snapshot of how:
Capital gains
Profits earned from investments are typically considered taxable gains—the profit you make if you sell an investment for more than you paid for it. For example, if you buy a stock for $100 and sell it for $150, you've made a $50 profit. The profit is likely considered a taxable capital gain.
Capital gains are classified as short-term or long-term based on how long you hold the investment.
- Short-term gains: Profits earned when you sell an investment within one year or less of buying are considered short-term gains. These are generally taxed as regular income.
- Long-term gains: Investments sold after a year or more are regarded as long-term capital gains and are usually taxed at a lower rate.
- Dividends: Some investments also pay dividends, which are cash payments to shareholders. Ordinary dividends are taxed as ordinary income, while qualified dividends are taxed at the same rate as long-term capital gains. You can find out if a dividend is ordinary or qualified from your annual tax forms.
Capital losses
On the flip side, capital losses can reduce your taxes by offsetting gains. If you sell an investment for a loss, it may offset any capital gains. For instance, if you make $100 on one stock but lose $20 on another, your total taxable profit would be $80.
Of course, it's better to make money and pay taxes than lose money. But it's nice to know that investment losses can lighten your tax burden.
READ MORE: 10 Lessons You Should Learn Before Investing
Types of Tax-Advantaged Investment Accounts
Using tax-advantaged accounts can help lower your taxes by allowing your investments to grow without being taxed right away—or even tax-free, in some cases. Common tax-advantaged accounts come with acronyms like IRA, 401(k), 529 and HSA. Here's a look at some of the most common tax-advantaged accounts.
Retirement accounts
Retirement accounts are broken down into two categories:
- Pre-tax accounts lower your taxes the year you contribute, but you'll have to pay taxes on withdrawals in the future. Most people expect to earn less in retirement, which may result in a lower tax rate on that income.
- After-tax accounts require you to pay regular taxes on income before contributing, even if you contribute for retirement. So they don't reduce your taxable income in the year you contribute. But future qualified withdrawals, including any investment earnings, are tax-free. This saves you from paying taxes on the larger amount, including growth and capital gains.
Your employer might offer a 401(k) account, where the company matches a portion of your contributions. Depending on your employer, they may instead offer a 403(b) or 457 account, but these work similarly to a 401(k). If you want to save for retirement outside of work, you can open and manage an individual retirement account (IRA), which does not include employer contributions. These are all examples of pre-tax accounts.
Roth IRA accounts are after-tax accounts that you can open and manage independently. Some employers offer Roth-designated 401(k) accounts with the same tax benefits.
While this isn't an exhaustive list, it gives you an idea of what's available. Be aware that annual contribution limits apply, and you may have to pay penalties and taxes if you withdraw before the IRS-mandated age for retirement account withdrawals.
Education savings accounts
If you want to save for education, consider a 529 plan. These accounts let you save and invest for qualified education expenses—like college or private school tuition—while enjoying tax advantages.
Many states offer 529 plans, but you don't necessarily have to participate in your state's plan. If you like the investment choices offered by another state, you may want to pick that state's plan.
If you don't use all the funds in a 529 plan, leftover balances can't be withdrawn for non-education purposes without losing the tax benefits. Non-qualifying withdrawals are subject to taxes and penalties. However, you can roll over unused funds to another family member's 529 plan.
Health savings accounts
A health savings account (HSA) is designed for people with high-deductible health insurance plans to save and invest for medical expenses, but savvy investors can use the account for retirement. These arguably offer some of the best tax advantages available, as contributions are tax-free, earnings grow tax-free and withdrawals are tax-free if used for qualified medical expenses.
You can contribute up to an annual limit set by the IRS. However, you can only contribute while you have an eligible health insurance policy. Once the money is in the account, it's yours to keep indefinitely.
Account holders can use the account to pay eligible medical expenses directly or reimburse themselves for out-of-pocket medical costs. You don't need to reimburse yourself immediately—saving receipts and deferring reimbursements allow the account to grow over time. This strategy can effectively provide tax-free income in retirement for past medical expenses.
How Real Estate Investing Impacts Taxes
Some investors want to diversify beyond traditional investments like stocks and bonds with real estate. However, as with other investments, taxes may affect your total profits. You may be able to delay those taxes if you sell a property and use the proceeds to buy a similar one—known as a 1031 exchange.
But it's not all bad news. You may save on taxes related to your investment property through depreciation. This allows you to deduct the wear and tear of the investment property over time, reducing taxable income. This deduction often applies even if the property's market value increases. Expenses related to an investment property may also be deductible.
Although rental property income may be taxable, it can be a valuable source of passive income that supplements or fully replaces other earnings over time.
Investment Expenses and Tax Deductions
When you spend money directly related to your investments, you can sometimes deduct the expense, effectively lowering your income for tax purposes.
One of the few allowed deductions is interest paid when you borrow funds for investment purposes, such as a margin loan. Deductions for investments can be complex, so it may be best to consult with a tax professional to avoid violating IRS regulations.
Reporting Investment Income and Losses on Your Tax Return
When tax season rolls around, you'll likely receive tax forms from the companies you use for investing. You'll use that information to prepare your income tax return, with one or more sections dedicated to your investments. Some of the most common tax forms you may receive with information about your investments include:
- Form 1099-DIV. Reports dividends and capital gains distributions from stocks, mutual funds or ETFs.
- Form 1099-INT. Reports taxable interest income from sources like savings accounts, bonds or certificates of deposit (CDs).
- Form 1099-B. Reports proceeds from the sale of securities like stocks, bonds or mutual funds, including cost basis and realized gains or losses.
- Form 1099-OID. Reports original issue discount income from certain bonds.
- Form 1099-R. Reports distributions from retirement accounts, such as IRAs or pensions.
- Form K-1 (Schedule K-1). Reports income, deductions and credits from partnerships, S corporations, trusts or estates.
After providing those forms to your accountant or adding the data to your preferred tax software, you may see a combination of these additions to your tax return:
- Schedule B (Form 1040). Used to report interest and ordinary dividends if they exceed $1,500.
- Schedule D (Form 1040). Used to report capital gains and losses from the sale of investments.
- Form 8949. Provides detailed reporting of individual capital asset transactions (e.g., stock sales) to support entries on Schedule D.
This is not an exhaustive list but covers the most common investment situations. Depending on where you invest, you may receive a consolidated 1099 statement with details from several forms in a single document.
Strategies for Minimizing Investment Tax Liability
Reducing investment-related taxes is an essential part of maximizing returns. Here are some effective strategies:
Buy and hold
Holding investments for more than a year qualifies for lower long-term capital gains tax rates. This strategy minimizes your tax burden and also encourages disciplined, long-term investing.
Tap into tax-advantaged accounts
Using tax-advantaged accounts—like 401(k)s, traditional IRAs and Roth IRAs—can significantly lower your tax liability. Contributions to 401(k)s and traditional IRAs reduce your taxable income now, with investments growing tax-deferred until withdrawal. Roth IRAs, funded with after-tax dollars, provide tax-free growth and withdrawals in retirement. Use these accounts to shelter your investments from taxes and help them grow more over time.
Consider tax-loss harvesting
As your investment accounts grow, you may be able to reduce your tax burden through a strategy called tax-loss harvesting. With this strategy, you can sell an investment at a loss and immediately buy another investment to replace it. You get the benefit of the capital loss while maintaining a similar portfolio.
Some investment companies offer automated tax-loss harvesting, using computer algorithms to identify tax-loss harvesting opportunities and lock in the trades for you. It's also possible to do it manually, but that's far less efficient.
While tax-loss harvesting can be a valuable tool, it's important to avoid missteps. You're not allowed to replace an investment with one that's "substantially identical," such as swapping an S&P 500 fund for another S&P 500 fund.
The losses can reduce your taxable income by up to $3,000 each year, and any leftover losses can be used in future years.
Staying Informed and Seeking Professional Advice
Staying up to date with current tax laws is crucial for maximizing investment returns and avoiding costly mistakes. Tax regulations can change frequently, impacting everything from capital gains rates to deductions for investment expenses. Regularly reviewing updates from the IRS or consulting reliable financial resources can help you stay informed and compliant.
While self-education is important, there are times when seeking professional advice is the best choice. A tax professional or financial advisor can provide tailored strategies to optimize your tax situation, especially if you have complex investments or significant gains. Their expertise can also help you navigate intricate areas like tax-loss harvesting, retirement account rules or estate planning.
Taking Charge of Investment Taxes
While taxes are an inevitable part of investing, the payoff from a well-planned long-term investment strategy typically outweighs the costs. If you work toward your investment goals and keep a keen eye on taxes, you're likely setting yourself up for financial success.
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