Taxes on Investments: The Basics to Know to Reduce Your Bill

What you pay (and when) depends on the type of investment and a few other factors.

Tina OremJuly 24, 2020
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Investing is a fantastic way to build wealth and security, but it’s also a fantastic way to create a hefty bill if you don’t understand how and when the IRS imposes taxes on investments.

Here are five common types of taxes on investments and what you can do to minimize what you owe.

Tax on capital gains

What it is: Capital gains are the profits from the sale of an asset — shares of stock, a piece of land, a business — and generally are considered taxable income.

How it works: The money you make on the sale of any of these items is your capital gain. For example, if you sold a stock for a $10,000 profit this year, you may have to pay capital gains tax on the gain. The rate you pay depends in part on how long you held the asset before selling. The tax rate on capital gains for most assets held for more than one year is 0%, 15% or 20%. Capital gains taxes on most assets held for less than a year correspond to ordinary income tax rates.

How to minimize it: You can reduce capital gains taxes on investments by using losses to offset gains. This is called tax-loss harvesting. For example, if you sold a stock for a $10,000 profit this year and sold another at a $4,000 loss, you’ll be taxed on capital gains of $6,000.

Tax on dividends

What it is: Dividends usually are taxable income in the year they’re received. Even if you didn’t receive a dividend in cash — let’s say you automatically reinvested yours to buy more shares of the underlying stock, such as in a dividend reinvestment plan (DRIP) — you still need to report it.

How it works: There are generally two kinds of dividends: nonqualified and qualified. The tax rate on nonqualified dividends is the same as your regular income tax bracket. The tax rate on qualified dividends usually is lower: It’s 0%, 15% or 20%, depending on your taxable income and filing status. After the end of the year, you’ll receive a Form 1099-DIV or a Schedule K-1 from your broker or any entity that sent you at least $10 in dividends and other distributions. The 1099-DIV indicates what you were paid and whether the dividends were qualified or nonqualified.

How to minimize it: Holding investments for a certain period of time can qualify their dividends for a lower tax rate. Remembering to set cash aside for the taxes on dividend payments can help avoid a cash crunch when the tax bill arrives, but holding dividend-paying investments inside of a retirement account can be a way to defer taxes on investments.

Taxes on investments in a 401(k)

What it is: Generally, you don’t pay taxes on money you put into a traditional 401(k), and while the money is in the account you pay no taxes on investment gains, interest or dividends. Taxes hit only when you make a withdrawal. With a Roth 401(k), you pay the taxes upfront, but then your qualified distributions in retirement are not taxable.

How it works: For traditional 401(k)s, the money you withdraw is taxable as regular income — like income from a job — in the year you take the distribution. If you withdraw money from a traditional 401(k) before age 59½, you may have to pay a 10% penalty on top of the taxes (unless you qualify for one of the exceptions). You may also have to pay a penalty if you wait too long to make withdrawals (after age 72). (Note: The age limit used to be 70½, and that limit still applies to anyone who turned that age in 2019.)

Roth 401(k) vs. traditional 401(k)

Traditional 401(k)

Roth 401(k)

Tax treatment of contributions

Contributions are made pretax, which reduces your current adjusted gross income.

Contributions are made after taxes, with no effect on current adjusted gross income. Employer matching dollars must go into a pretax account and are taxed when distributed.

Tax treatment of withdrawals

Distributions in retirement are taxed as ordinary income.

No taxes on qualified distributions in retirement.

Withdrawal rules

Withdrawals of contributions and earnings are taxed. Distributions may be penalized if taken before age 59½, unless you meet one of the IRS exceptions.

Withdrawals of contributions and earnings are not taxed as long as the distribution is considered qualified by the IRS: The account has been held for five years or more and the distribution is:

  • Due to disability or death

  • On or after age 59½

Unlike a Roth IRA, you cannot withdraw contributions any time you choose.

How to minimize it: If you have to take money out of the account before you’re 59½, see if you qualify for an exception to the penalty. Tax-loss harvesting, borrowing from the account rather than withdrawing, and rolling over the account are also ways to minimize taxes on investments.

» MORE: Find out about rules and strategies for traditional 401(k) and Roth 401(k)

Tax on mutual funds

What it is: Mutual fund taxes typically include taxes on dividends and capital gains while you own the fund shares, as well as capital gains taxes when you sell the fund shares.

How it works: Your mutual fund may generate and distribute dividends, interest or capital gains from the investments inside the fund. Accordingly, you may owe taxes on these investments — even if you haven’t sold any of the shares or received any cash from them. The tax rate you pay depends on the type of distribution you get from the mutual fund, as well as other factors. If you sell your mutual fund shares for a profit, you might incur capital gains tax.

How to minimize it: Waiting at least a year to sell your shares could lower your capital gains tax rate. Holding mutual fund shares inside a retirement account could defer the tax on the interest, dividends or gains your mutual fund distributes. Tax-loss harvesting and choosing funds less likely to distribute taxable income are other options.

Tax on the sale of a house

What it is: If you sell your home for a profit, some of the gain could be taxable.

How it works: The IRS typically allows you to exclude up to $250,000 of capital gains on your primary residence if you’re single and $500,000 if you’re married and filing jointly. Say you and your spouse bought a home 10 years ago for $200,000 and sold it today for $800,000. If you file your taxes jointly, $500,000 of that gain might not be subject to the capital gains tax (but $100,000 of the gain could be). What rate you pay on the other $100,000 would depend in part on your income and your tax-filing status.

How to minimize it: You have to meet certain criteria in order to qualify for this exclusion, so be sure to review them before you sell. You might qualify for an exception, and adding the value of home improvements you’ve made could help.

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