Yes! An entire article on taxes! We’ll file this under the category of things that no one really ever says (out loud, anyway). While the tax treatment of investments is probably not at the top of your reading list, you may still be curious about how and when investment income is taxed by the IRS.
If you invest across a few different types of securities, it’s important to know that each type of investment income you earn comes with its own set of tax rates and rules (see IRS Publication 550). You’re probably feeling a sneaking suspicion that this tax stuff is about to get complicated. Don’t worry, we’ll provide a few examples in our discussion below.
Before we dive in, however, keep in mind that while we can help bring you up to speed on the basics here, it’s a good idea to consult a tax advisor about your personal tax situation and what rules may apply to your specific investments.
Wouldn’t it be nice if we could keep all the money we make? Alas, when you earn income, whether that’s through your job or your investments, you typically have to give a portion of it to the tax man at the IRS. Depending on where you live, you might also have to pay taxes at the state and local level. But for right now, let’s focus on federal taxes.
How investments are taxed depends on several factors, including the type of account, the type of income you earned, and when the assets were sold. Here are some common types of federal taxes on investments and how they may be applied.
If you own stocks, you’re probably already familiar with dividends, which are payments from the earnings and profits of a company or corporation in which you’re a shareholder. In the eyes of the IRS, dividend payments are taxable.
How the tax works: Not all dividends are taxed the same way. The tax rate varies depending on your tax bracket and whether the dividends are considered “ordinary” or “qualified.”
Generally speaking, dividends from the stocks of U.S. corporations are considered qualified, so long as you’ve held the stocks for more than 60 days.
You’ll likely have to pay taxes on the interest you earn from bank deposit accounts (think: savings accounts, certificates of deposit) as well as debt securities like corporate bonds.
How the tax works: This one is relatively straightforward: Most interest income is treated like ordinary income. In other words, it’s taxed at your ordinary income rate. However, interest payments from certain types of bonds, such as municipal bonds, may be tax exempt. Generally, many bonds issued by state and local governments are exempt from federal income tax (but they may still be subject to state and local taxes in certain cases).
When you invest, you may also earn what is known as capital gains, which is the profit that you make when you sell an asset such as a stock, bond or Exchange-Traded Fund (ETF). Capital gains are considered “realized” when you actually sell your investment, and the money that you make from the sale is generally taxable.
How the tax works: The tax you pay on your capital gains depends on how long you’ve held onto your investments (short term vs long term).
Because you could sell multiple assets in a given year, it can get a little tricky trying to figure out your potential capital gains tax. You typically need to figure out details like: how long you held onto the assets; cost basis (translation: how much you originally paid for the assets); and net capital gain (or loss). These calculations are no walk in the park, so it’s a good idea to consult with a professional tax advisor who can help you accurately crunch the numbers.
Good to know: Sometimes, in a tough investment year, you might experience a “capital loss,” where you lose money from your investment sales. Generally, you can deduct up to $3,000 net capital losses a year on your tax return ($1,500 if married filing separately).
If you’re planning on deducting tax losses, definitely consider checking in with a tax professional to ensure you’re not violating the IRS wash-sale rules (see IRS Publication 550). A wash sale is when you sell or trade an investment at a loss and purchase a substantially identical investment within 30 days before or after the sale. According to IRS rules, you cannot deduct losses related to wash sales.
When you invest through a fund like a mutual fund or ETF, the fund typically distributes any dividends, interest or capital gains earned from the securities held within the fund’s portfolio at the end of each year.
How it works: The tax you potentially owe on those distributions depends on the securities that the fund holds and how long they’ve been held. The type of distribution you receive is also a factor. For instance, if you’re invested in a bond fund, you may receive interest distributions that are considered taxable interest income. Or if you’re invested in a stock fund, you may have to pay taxes on your dividends.
One important thing to keep in mind, too, is that distributions may be taxable even if you don’t take the money out of your account (for example, if you simply reinvest them to buy more shares).
Good to know: If you sell shares of the mutual fund or ETF itself and make a profit, you may also owe taxes from the sale of those shares (realized capital gains).
So far we’ve talked about taxes on investment earnings from individual types of securities like bonds, stocks and funds. But there’s another type of investment tax that you should be aware of – the Net Investment Income Tax (NIIT).
This type of tax is a little bit different from the ones we’ve covered so far. That’s because the NIIT isn’t imposed on any one specific type of investment earnings or profit. Rather, it’s a 3.8% tax applied to the net investment income of individuals whose income exceed certain dollar amounts (ranging from $125,000 to $250,000, depending on your filing status).
Now, what does the IRS consider as investment income? Generally, net investment income includes interest payments, dividends, capital gains, rental and royalty income, as well as non-qualified annuities. See the IRS webpage for more information.
Whew! That was a lot of investing tax information to take in. You may now be wondering how you’ll report all this to the IRS. Thankfully, this part is relatively easier to do.
If you have any investment account, your financial firm should send you information about your holdings each year, which you can use to help file your income tax return.
You may either get these tax documents in the mail or online. These tax documents are essentially a summary report on the various types of income generated by your investments such as stocks, bonds, mutual funds and ETFs – as well as a form listing capital gains or losses from any securities sales.
Firms may use some of the following forms to report your investment income to you (and to the IRS):
Gathering all the necessary documents and forms in order to file your federal income tax return can be a real chore (whether you’re doing it yourself or with the help of a professional). And trying to figure out your investment tax obligations can add another layer of stress. But remember – this isn’t something you have to do on your own. Definitely consider working with a professional financial and tax advisor who could help ensure that you’re reporting your investment income accurately to the IRS and that you understand what kind of investment taxes you may potentially owe at the end of the tax year.
This article is for informational purposes only and is not a substitute for individualized professional advice. Individuals should consult their own tax advisor for matters specific to their own taxes and nothing communicated to you herein should be considered tax advice. This article was prepared by and approved by Marcus by Goldman Sachs, but does not reflect the institutional opinions of Goldman Sachs Bank USA, Goldman Sachs Group, Inc. or any of their affiliates, subsidiaries or division. Goldman Sachs Bank USA does not provide any financial, economic, legal, accounting, tax or other recommendation in this article. Information and opinions expressed in this article are as of the date of this material only and subject to change without notice. Information contained in this article does not constitute the provision of investment advice by Goldman Sachs Bank USA or any its affiliates. Neither Goldman Sachs Bank USA nor any of its affiliates makes any representations or warranties, express or implied, as to the accuracy or completeness of the statements or any information contained in this document and any liability therefore is expressly disclaimed.