How are investments taxed? Lowering your tax bill on stocks, options and more

Key findings

  • You pay taxes on investment gains when you sell an investment or receive an interest or dividend payment
  • If you hold an investment for at least a year, you will pay taxes at a lower rate
  • Accounts like 401(k)s or IRAs can help reduce your investment taxes

Every April, Americans file their tax returns and settle their accounts with the IRS. Taxes can have a significant impact on your investment portfolio and its performance. Understanding how the IRS taxes investments and how to limit those taxes is an integral part of any investment strategy.

Here’s what investors need to know to lower their tax bills.

How are stocks, mutual funds and ETFs taxed?

When you invest in stocks, mutual funds, or ETFs, you typically earn returns in two ways. These include selling your investment for a profit and receiving dividends. These investment gains are treated differently at tax time.

Capital gains taxes

When you buy an investment like stocks or mutual funds, your broker will note the price you paid for that security. The price you pay is the cost base for your investment.

When you sell an investment, you compare the selling price to your cost basis. If you sell at a profit, you earn a capital gain. If you sell at a loss, you have a capital loss.

At the end of the year, you must pay taxes on your total capital gains. For example, if you earned a $10,000 capital gain on one stock and had a $5,000 capital loss on another investment, you would only pay taxes on the net gain of $5,000.

Capital gains are further divided into long term and short term capital gains. You get short-term gains on investments held for less than a year and long-term gains on investments held for a year or more.

Income tax on short-term gains is paid as if those gains were regular income. Otherwise, you pay a lower tax rate on long-term gains.

The single filer tax rates for 2022 are:

Tax rates on short-term capital gains

$0 – $10,275

10%

$10,276 – $41,775

12%

$41,776 – $89,075

22%

$89,076 – $170,050

24%

$170,051 – $215,950

32%

$215,951 – $539,900

35%

$539,001+

37%

Long-term capital gains tax rate

$0 – $41,675

0%

$41,676 – $459,750

15%

$459,751+

20%

Taxes on dividends

There are two categories of dividends to consider, including qualified and non-qualified.

By default, all dividends are non-qualified. The exception is if the dividend is paid by a U.S. corporation or a qualified foreign corporation and you have held your stock in the company for at least 60 days during the 121 days beginning 60 days before the ex-dividend date.

The IRS taxes nonqualified dividends as ordinary income. If you have qualified dividends, they are subject to long-term capital gains tax.

Lowering your taxes on stocks, mutual funds and ETFs

One of the nice things about stocks is that you only pay capital gains taxes when you sell your investment. Some mutual funds make annual capital gains distributions, but you can still limit your tax bill by holding onto your shares.

You can reduce your capital gains taxes simply by holding investments for longer periods. If you don’t sell, you won’t owe taxes. You can also consider tax loss harvesting, which involves strategically selling underperforming investments at a loss to reduce your overall gains.

Limiting taxes on dividends can be more difficult. One effective strategy is to hold dividend-paying investments in tax-advantaged accounts such as a 401(k) or IRA so that you don’t have to pay taxes on the income.

How are bonds taxed?

Taxes on bonds depend largely on the issuer of the bond and how you earn on the investment.

You can buy and sell some bonds on the open market, just as you can with stocks and other securities. If you make a capital gain from a bond investment, you will pay taxes on the capital gain.

However, most people earn profit from bonds through interest payments. Any interest earned on a bond is treated as taxable income.

Certain special bonds are exempt from certain taxes. For example, municipal bonds issued by state or local governments are generally tax-free at the federal level. Some states also exempt municipal bond proceeds from state income taxes.

The IRS taxes the income from bonds issued by the federal government, but they are generally exempt from state and local income taxes.

Tax cuts on bonds

Bonds are generally tax inefficient because your interest payments are treated as regular income.

The best way to reduce taxes on bonds is to hold bonds in a tax-advantaged investment account. If you must hold bonds in a taxable account, you might consider municipal bonds or federal government bonds, which are exempt from certain taxes.

How are options taxed?

The majority of underlying options trades generate short-term profits and losses. This means you will pay tax on your total earnings at your ordinary income tax rate.

There are some exceptions to this rule. For example, options with expiration dates more than a year into the future can generate long-term gains or losses. The tax treatment of more complex strategies, such as covered calls, straddles or forward puts, can be complicated.

If you plan to use these high-level options trading strategies, consult a tax professional or your broker for advice on how the IRS will tax your trades.

The bottom row

Nobody likes paying taxes, but they cannot be avoided. Understanding how they affect your investments is an important part of maximizing your investment portfolio.

To reduce investment taxes, consider using tax-advantaged accounts like a 401(k) or IRA for your least tax-efficient investments, such as dividend-paying stocks, and hold your investments for at least a year before selling.

If you need help creating a tax-efficient portfolio, consider working with Q.ai. Its artificial intelligence can help build a portfolio for almost any objective and economic climate. With its investment kits, investing can be easy and fun.

Download Q.ai today to access AI-powered investment strategies.

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