What Gets Taxed?
In the U.S., investment income is taxed in several ways. Understanding this helps you keep more of what you earn.
Capital Gains
When you sell an investment for more than you paid, the profit is a capital gain.
- Short-term (held under 1 year) — Taxed as ordinary income at your marginal rate. Could be 10% to 37% depending on income.
- Long-term (held 1 year or more) — Gets preferential rates: 0%, 15%, or 20% depending on your income. This is a big incentive to hold investments for the long term.
Dividends
- Qualified dividends — Get the same favorable rates as long-term capital gains. Most dividends from U.S. stocks held more than 60 days are qualified.
- Non-qualified dividends — Taxed as ordinary income. REITs and some foreign stocks often pay non-qualified dividends.
Interest
Interest from bonds, CDs, and savings accounts is taxed as ordinary income at the federal level. Some municipal bond interest is tax-free at the federal level.
Tax-Advantaged Accounts Reduce the Pain
| Account | Contributions | Growth | Withdrawals |
|---|---|---|---|
| Traditional IRA / 401(k) | Often deductible now | Tax-deferred | Taxed as income |
| Roth IRA / Roth 401(k) | After-tax | Tax-free | Tax-free (qualified) |
| Taxable brokerage | After-tax | Taxed on dividends yearly; gains when you sell | Capital gains / dividend tax |
Use tax-advantaged accounts first. A dollar in a Roth that grows tax-free can be worth significantly more over decades than the same dollar in a taxable account.
Tax-Loss Harvesting
If you sell an investment at a loss, you can use that loss to:
- Offset capital gains — Dollar for dollar. If you have $5,000 in gains and $3,000 in losses, you pay tax on $2,000 of gains.
- Offset ordinary income — Up to $3,000 per year. Losses beyond that carry forward to future years.
This is called tax-loss harvesting. It can lower your tax bill, but don't let taxes drive bad decisions. Selling a good investment just to harvest a loss may not be worth it if you believe in it long-term.
IMPORTANT
Wash-sale rule: If you buy the same or "substantially identical" security within 30 days before or after the sale, the IRS may disallow the loss. For example, if you sell VTI at a loss and buy VTI again within 30 days, the loss is postponed. Be careful when harvesting losses in taxable accounts.
Practical Tips
- Hold investments at least one year when possible to get long-term capital gains rates.
- Put high-dividend or high-turnover investments in tax-advantaged accounts (IRA, 401k) where possible. Keep tax-efficient index funds in taxable.
- Don't sell just to rebalance in taxable if it triggers big gains. Use new contributions to rebalance instead.
- Keep records of your cost basis. Brokers report this, but it helps to have your own records.
Note
Tax laws change. Contribution limits, rates, and rules are updated periodically. Check the IRS website or consult a tax professional for your situation.