By Dr. James M. Dahle, WCI Founder
Some new investors are surprised to learn that their tax bill goes up when they start investing. While investments often receive favorable tax treatment compared to earned income, the income they produce is generally taxable at some point and at some rate. We'll go over each type of investment and how it is taxed.
Do You Have to Pay Taxes on Stocks?
Stocks are generally very tax-efficient assets and thus a good investment for those who invest in a taxable account. When investing in stocks, you generally make money in two different ways: dividends and capital gains.
Tax on Dividends
Stock dividends are taxable in the year they are received. Most stock dividends are “qualified.” The IRS is the one who does the qualifying, and qualified dividends are eligible for the lower qualified dividend tax brackets as opposed to the ordinary tax brackets. The good news is that most Americans are actually in the 0% qualified dividend tax bracket. The bad news is that most readers of this blog (and truthfully, most people who have to pay tax on qualified dividends) are not in the 0% bracket.
Some dividends, however, are “unqualified.” These include REIT dividends as well as dividends for any stock you did not hold for at least 60 days. Unqualified dividends are taxed using the ordinary income tax brackets, i.e. your marginal income tax rate. REIT dividends are, however, eligible for the 199A deduction. Note that if you are a high-earner (>$200,000 single, $250,000 married filing jointly), you will also have to pay 3.8% in Obamacare Tax (officially Net Investment Income Tax) on that income. You may also owe state income taxes. Note that you may qualify for an income tax credit for taxes paid by your foreign stocks to other countries.
Tax on Capital Gains
How much you pay on capital gains depends on how long you owned the investment, whether in stocks, real estate investments, or even your home. In fact, if you sell a consumer good like a car or a boat for more than you paid for it, you are supposed to pay capital gains tax on it. If you owned the investment for longer than one year, this is referred to as a Long Term Capital Gain (LTCG) and is taxed at a lower rate, which happens to be precisely identical to the qualified dividend tax brackets. You will not have to pay Social Security or Medicare taxes on this income, but you may have to pay Net Investment Income Tax (3.8%) or state income taxes on it.
If you owned the investment for one year or less, you will pay short-term capital gains rates, which are precisely equal to your ordinary earned income tax rates.
Unlike taxes on dividends and interest, capital gains taxes are only paid when you sell. No sale, no tax. If you have any tax losses, those are actually subtracted against your gains and you only pay taxes on the net total. You can even use those losses against up to $3,000 of your ordinary income each year and carry over any extra.
If you give appreciated stocks to charity, there is no tax due from you or the charity on any capital gains. You may even be able to place the donation on Schedule A as an itemized deduction. However, you have to have owned the stock for at least one year to deduct the gains in addition to the basis (the amount you paid for it).
If you die, your heirs benefit from the step-up in basis, and they can immediately sell the asset without any capital gains taxes due, no matter how much the stock (or any asset) appreciated while you owned it.
Do You Have to Pay Taxes on Bonds?
The vast majority of your investment return on bonds is taxed as interest.
Tax on Interest
Interest is taxable in the year it is received. It is taxed in exactly the same way as ordinary or non-qualified dividends. You can simply use the earned income tax brackets to figure it. You do not pay Social Security or Medicare tax on it, but you do pay Net Investment Income Tax (3.8%) and perhaps state income tax on it.
If you sell a bond at a profit before it matures, you will also owe capital gains taxes on that sale. Those gains will be taxed at the short-term capital gains rates (equal to the regular, ordinary income tax brackets) if you owned the investment for one year or less, or it will be taxed at the lower long-term capital gains rates if you owned the investment for more than a year.
There are some unique types of bonds that receive special tax treatment. Savings Bonds—both type EE and type I—are not taxed until they are sold. Treasury bond interest is state and local income tax-free. Municipal bond interest is always federal income tax-free and sometimes can be state and local income tax-free, too. Foreign bonds may also provide you with a foreign tax credit.
Do You Have to Pay Taxes on Mutual Funds or ETFs?
Traditional mutual funds and ETFs are pass-thru entities as far as interest, dividends, and capital gains go. The fund itself does not pay any taxes for you. It simply adds up all of the income from the securities inside the fund (whether stocks, REITs, or bonds), pays its expenses, and distributes the rest to you as interest, non-qualified dividends, qualified dividends, short-term capital gains, or long-term capital gains. The most tax-efficient mutual funds or ETFs are broad-based, low-cost stock index funds such as the Vanguard Total Stock Market Fund and municipal bond funds. Stock index funds generally only distribute qualified dividends each year. Municipal bond funds generally only distribute federal income tax-free interest each year. So very little tax is paid on either of these types of mutual funds until they are sold, at which point the usual short- and long-term capital gains rates apply.
Do You Have to Pay Taxes on Real Estate?
Real estate interest is taxed in the year received at ordinary income tax rates. If the real estate entity is a REIT, it will qualify for the 199A deduction, potentially reducing the tax bill by 20%. Real estate rents are taxed at ordinary income tax rates. However, you first get to deduct all business expenses from that rent before paying taxes on it. Rental properties that don't cash flow may not even have any profit left to pay taxes on. However, a more likely scenario is that the owner will receive rent/profits but can shelter part or even all of it with depreciation. While depreciation is recaptured at the time of sale, it is only recaptured at a rate of up to 25%, so there is an arbitrage available there—both in delaying the payment of that tax and in reducing the amount of that tax for most real estate investors.
When a property is sold, the investor will pay depreciation recapture in addition to either short-term or long-term capital gains rates on any appreciation. If the property sold has been your residence for two of the last five years, you can exclude up to $250,000 ($500,000 if married filing jointly) from the gains. An investor can do a “1031 exchange” into a similar property and defer both depreciation recapture and capital gains taxes. If the investor does this the all way to his or her death, the heirs will receive a step-up in basis at death, just like with a stock, bond, or mutual fund. Unfortunately, you cannot 1031 exchange your residence.
How to Avoid Paying Tax on Investments as They Grow?
There are three main ways to avoid paying taxes on investments as they grow.
#1 Pick Tax-Efficient Investments
The first step is to simply pick investments that are very tax-efficient, such as broadly diversified stock index funds and municipal bond funds.
#2 Buy and Hold (and Tax-Loss Harvest)
The second step is to avoid selling those investments as much as possible. This avoids short-term capital gains taxes but can even reduce or eliminate long-term capital gains taxes. Capital gains taxes are only paid when you sell a winning investment, so if you avoid selling, you avoid the tax. You can reduce taxes even more by exchanging losing investments for similar but not “substantially identical” investments in a process called Tax-Loss Harvesting. The losses you harvest by doing that can be used to reduce current or future long-term capital gains taxes.
#3 Use Tax-Protected Accounts
Most importantly, if you will invest inside tax-protected accounts such as 401(k)s, 403(b)s, 457(b)s, 401(a)s, SEP-IRA, SIMPLE IRAs, SIMPLE 401(k)s, Defined Benefit/Cash Balance Plans, traditional IRAs, Roth IRAs, HSAs, 529s, ESAs, and ABLE accounts, you can avoid paying any of these taxes. With a tax-free account (Roth 401(k)s, Roth 403(b)s, Roth 457(b)s, Roth IRAs, and, if used appropriately HSAs, 529s, ESAs, and ABLE accounts) you won't pay any taxes at all on interest, dividends, or capital gains.
With a tax-deferred account (all the others listed above), you only pay taxes (at ordinary income tax rates) on withdrawals from the accounts—not on any investment gains, interest, or dividends.
How Much Are Stocks Taxed?
It depends—done properly, very little or even nothing at all. But in general, the more successful the company and the more you want to actually use the money you invested in the stock, the more you will pay. Let's use a simple example to demonstrate.
Berkshire-Hathaway stock does not pay any dividends. If you bought a share in 1994 for $16,000, it has since appreciated to about $430,000. If you sell your share, and you are in the 20% long-term capital gains tax bracket, you will pay $430,000 – $16,000 = $414,000 * 20% = $82,800 in long-term capital gains taxes. You will likely also owe 3.8% ($15,732) in Net Investment Income Tax for a total of $98,532. If you decided to leave that share to your heirs or a charity, no tax at all would be owed.
Let's use a different example. Let's say you own 100 shares of GE stock. You bought them for $100 apiece, or $10,000 total. You sell them a little over a year later for $110 a share, or $11,000 total. Meanwhile, it paid out $300 in qualified dividends. If you are in the 20% qualified dividend and long-term capital gain brackets, you will owe 20% * $11,000-$10,000 = $1,000 * 20% = $200 in long term capital gains taxes plus 20% * $300 = $60 in qualified dividend tax plus 3.8% * $1,300 = $49 in Net Investment Income Tax for $309 in total tax on a gain of $1,000 and a qualified dividend of $300.
Do Investments Count as Income?
Investments themselves do not count as income, but the income that investments provide certainly counts as taxable income in the eyes of the IRS. There are very few exceptions, the most notable of which are investments inside of tax-protected accounts and municipal bond interest.
When Do You Get Taxed on Investments?
The general rule is that you pay taxes on investment income in the year it is received. For dividends and interest, that's going to be every year. For capital gains and recapture of depreciation, that will be the year the investment is sold. Remember that the federal income tax system (and some state income tax systems) are “pay as you go” systems. That means if you receive income in the first quarter of the year, you are supposed to pay tax on it in the first quarter of the year—not the next year on April 15 when the tax return is due. So large amounts of investment income may require you to pay quarterly estimated taxes to stay within the safe harbor, even if you are not self-employed.
How to File Taxes for Investments
For most people, you simply hand any tax forms your investments send you to your accountant and let the accountant deal with them. Alternatively, you enter those forms into your tax software as instructed. You will find that the software generally places investment income onto Schedule B (Interest and Ordinary Dividends), Schedule D (Short- and Long-Term Capital Gains), Schedule E (Real Estate), Form 1040 (Qualified Dividends), and Schedule K-1 (Real Estate Partnerships). The figures on those schedules will eventually flow through onto the main return, i.e. Form 1040.
Investments often benefit from favorable taxation. This is to encourage investment (which benefits both the investor and society at large) and, at least with regards to long-term capital gains, to acknowledge the fact that part of your gain is simply inflation and not a real increase. Understanding how investments are taxed will help you to pay less in tax and reach your financial goals more quickly.
What do you think? What was your biggest surprise when it came to investment-related taxes? Do you have any questions? Comment below!