Taxes on Investments: How They Work & Tax Forms To File

How Are Investments Taxed?

In general, taxes on investments are levied on your returns from those investments in the year that you receive (i.e., “realize”) those returns. Investment returns can be in the form of interest, dividends, or appreciation and all three forms are subject to tax unless you have one of the few investments that are either exempt from tax or sheltered from it. We’ll discuss the general tax rules first as well as some of the most common exceptions.

1. Capital Gains Taxes

‘Capital gains‘ (or losses) are the tax terms used to describe appreciation in the value of an investment. Investments like stocks can move up or down in value continually, but if you haven’t sold them, the daily fluctuations in value are viewed as “unrealized” and are not taxed. The Internal Revenue Service requires that you pay tax only on realized capital gains and that occurs once you sell the investment or it liquidates and returns your money to you. The difference between your sale or liquidation value and the purchase value represents your taxable capital gain.

Note: Every time you buy and sell a particular stock during a given year, you will generate a capital gain or loss. At the end of the year, you’ll need to add up all your transactions in your tax filing to arrive at a net gain or loss for the year. Your broker will generally provide you with a list of completed transactions to help at tax time, but if not, then you will need to create one from your statements.

Selling an investment, or having it mature and return your money constitutes a “taxable event”. Similarly, if you initiate a transaction by short selling an investment, such as a stock or option, the taxable event occurs when you repurchase it to close your position, or it expires if it is an option.

The amount of tax you are required to pay on capital gains depends on how long you have held the investment and on your income level. Gains for investments held for less than one year are considered short-term gains and those on investments held for more than one year are called long-term gains. Long-term gains are taxed at either 0%, 15%, or 20% depending on your income, whereas short-term gains are taxed as ordinary income.

Note: When you calculate how much tax you owe on capital gains, you are permitted to offset your gains with losses during the same year to come up with a net overall gain or loss for the year. You then pay tax on the net gain. If you have a net loss, you can use that loss to reduce the tax you may owe on earned income, but only up to $3000 per year. Capital losses larger than that are carried forward to the next year.

2. Interest & Dividends Taxes

Interest and dividends from your investment (whether you reinvest them or not) are taxable in the year they were paid to you. Both are generally taxed at ordinary income rates but qualified dividends are eligible for a reduced tax rate.

An exception to the interest rule is the interest paid by government-issued bonds. The states do not tax the interest on federal government bonds such as US Treasury bonds, and the federal government does not tax the interest from state or municipal bonds. Municipal bonds are free of both federal and state taxes if issued by the state in which you reside.

3. 401k and IRA Taxes

Taxes on investments held in retirement or college savings accounts are deferred while the money remains in the account as long as the account owner meets the respective rules and requirements. (You won’t need to report them either.) Upon withdrawal from these accounts, tax liabilities vary are as follows:

• Withdrawals or payouts from 401k plans, 403b plans, pension plans, and traditional IRA accounts are taxed as ordinary income.
• Withdrawals from Roth IRA accounts are tax-free if you are older than age 59 1/2 and other requirements are met.
• Withdrawals from college savings plans are tax-free if requirements are met.

Note: If requirements are not met on retirement accounts or college savings accounts, an account holder may be liable for paying deferred taxes on all prior interest and gains plus a 10% penalty.

4. Mutual Fund & ETF Taxes

Mutual funds and ETFs are required to pass their tax liability on gains to their shareholders. Holders of shares in these funds receive notice from the funds toward the end of the year regarding their proportional share of the tax liability and must report that on their individual tax returns.

Separately, fund shareholders are responsible for any capital gains or losses they incurred on the shares of the fund they may have sold during the year.

Note: Funds allocate their tax liability to the shareholders of record on a specified date, usually in late October. If you are a shareholder on that date, you will receive a tax allocation. An investor who purchases shares in the fund in September might only have been on the fund for one month but will receive a year’s worth of tax liabilities. Conversely, an investor who owned shares all year and sold in September would have no share of the fund’s tax liability for that year.

5. REIT Taxes

REITs may have both income and capital gains to pass on to their shareholders, which they do in a similar fashion to the way mutual funds do it. Many REITs, however, are able to reduce their tax liabilities by depreciating their assets or deducting operating expenses. As a result, some of the income distributions from REITs are passed to shareholders tax-free. Each REIT will be different in this regard and it will also vary from year to year.

How Investments Impact Taxes

Taxes on your investments are, for the most part, separate from the taxes paid on your income. However, there are three ways in which the taxes you pay on your investments may be impacted by the tax you pay on your income or vice versa.

• Income from investments is taxed at your personal income tax rate, which depends on your earned income.
• If you have net capital losses from investments in a given year, you can use those losses to reduce some of your personal income tax liability, though that is limited to $3000 in any single tax year.
• Your level of income also determines the tax rate you will pay on capital gains, so the more income you have, the higher your tax rate will be on your investment gains also.

How To Pay Taxes On Investments

Taxes on investment gains, interest, and dividends are filed along with your personal income tax filing and paid at the same time. Your summary 1040 tax filing combines all your investment taxes with your ordinary income taxes and gives you one net figure that you will either need to pay or receive as a refund.

You can elect with some financial institutions to have estimated taxes withheld from investment income, but that is not often the case, nor will you have any money withheld for taxes from your investment sales. Consequently, large capital gains in a particular year will result in having to pay hefty taxes out of pocket at tax time.

Also, your financial institution only knows what assets you have with them and cannot provide information on assets held elsewhere. As such, it is the responsibility of the taxpayer to record all taxable gains and losses for the year on a Schedule D form when filing your income tax.

Investment Tax Forms

Investment tax information is generally supplied to you by the financial institution or other entity where you hold investments. In the same way that your employers report your income on W-2 forms, you will receive 1099 forms with your investment income and dividends as well as annual summary statements from firms where you made securities transactions. It is then your responsibility to fill out IRS Form 8949 to figure out your net gains or losses for the year across all capital assets.

Once you have all the forms with information on your income and gains from investment assets, you’ll need to transfer those numbers to your Form 1040 and Schedule D filing forms. You will also need to report contributions to retirement or college savings accounts reported to you on Form 5498 or 5498-ESA, some of which may be tax-deductible and actually reduce your taxable income.

Tax Efficient Investing Strategies

In general, people have somewhat greater flexibility with regard to reducing the tax on their investments than they do in reducing the tax on their income from employment. The following methods are ways in which investors can implement tax-efficient strategies to reduce the taxes on their investments:

• Maximize the use of qualified retirement plans such as 401ks and IRAs.
• Use college savings accounts when investing for children’s education.
• Invest in vehicles that can be held for longer periods of time to get lower long-term tax rates.
• Offset taxable gains with tax losses where possible to reduce tax liability in a given year.
• Consider tax-advantaged investments such as municipal bonds or REITs.
• Consider ETFs over mutual funds, as ETFs are structured such that there are little or no tax liabilities passed through to shareholders each year.

Bottom Line

It is important to remember that what you actually earn from investments is what you get to keep after taxes are paid. Using some of the strategies mentioned above, you may be able to increase your overall returns from investments by reducing the tax you pay on them.