4 Tax Tips Every Investor Should Know

  by Shelley Seagler

Benjamin Franklin once said, “Nothing can be said to be certain, except death and taxes.” While investment returns are never a guarantee, the government will always want its share of your profits.

There are several ways to earn investment income, including dividends, capital gains, and interest. The amount of tax you owe on these sources of income depends on your tax bracket, holding period, and other factors. Fortunately, there are many strategies that you can use to minimize taxes and maximize your portfolio’s after-tax income.

Let’s take a look at different types of investment taxes and strategies that you can use to minimize them.

What Taxes Do Investors Owe?

Taxes on Interest

Most people are familiar with interest income from bank accounts or certificates of deposit (CDs). However, interest income also comes from money market products and bond coupon payments. You may even generate interest income from mutual funds or exchange-traded funds (ETFs) that pay “interest dividends” to shareholders.

Interest income is generally subject to state and federal income tax at your marginal tax rate. So, for example, an investor that falls into a 28% tax bracket and earns $1,000 in interest income owes $280 in taxes on that income, assuming they don’t have any deductions. However, we’ll discuss some sources of exempt interest income later.

Taxes on Dividends

Many investors seek out dividend-paying stocks to generate income while maintaining capital gains potential. Most mutual funds and ETFs pay some dividends since about half of U.S. stocks pay a dividend. But, of course, some stocks and funds offer higher dividends than others, meaning your level of dividend income may vary.

Free Worksheet: Organize Your Investments to Maximize Tax Efficiency

The amount of tax you owe on dividend income depends on its classification:

  • Qualified – Qualified dividends are subject to a 0%, 15%, or 20% tax rate, depending on your income. Most U.S. companies and American Depositary Receipts (ADRs) have qualified dividends, but you must have held the stock for over 60 days.
  • Non-Qualified – Non-qualified dividends are subject to your marginal tax rate. Most non-qualified dividends come from real estate investment trusts (REITs), master limited partnerships (MLPs), or foreign investments. Although some funds that own foreign stocks pass-through taxes to shareholders, reducing your dividend amount.

Capital Gains Taxes

Capital gains is a fancy way of saying the profit from the sale of an investment. In other words, it’s the difference between the amount you paid and the sale proceeds. While you may have a lot of unrealized capital gains, you only pay tax when you realize them. As a result, you may never pay these taxes if you never sell the investment.

2022 Tax Brackets

Income tax rates for 2022. Source: Forbes

There are two types of capital gains:

  • Long-term – Long-term capital gains are proceeds from investments you’ve held for more than a year. Depending on your income, these proceeds are subject to 0%, 15%, or 20% tax.
  • Short-term – Short-term capital gains are proceeds from investments you’ve held for less than a year. These proceeds are subject to your marginal tax rate.

Other Investment Taxes

Investment income may be subject to an additional 3.8% tax if you’re above a certain income threshold. In particular, you may owe the tax if your modified adjusted gross income is more than $200,000 as a single filer or $250,000 as a joint filer.

Some alternative investments may also have different tax rates. For instance, fine art and wine investments are subject to the 28% collectibles tax rate or your marginal tax rate (whatever is lower). Meanwhile, real estate income may be subject to different tax rates.

4 Strategies to Reduce Taxes

#1. Consider tax-efficient investments.

Municipal bonds are exempt from federal, state, and/or local taxes. As a result, investors in higher tax brackets or living in high-tax states may find the after-tax yields of muni bonds competitive with higher-risk corporate bonds. If that’s the case, muni bonds may be preferable due to their lower default rates and improved liquidity versus corporate bonds.

Tax-managed mutual funds provide similar benefits. In these funds, managers try to minimize taxes by avoiding dividend stocks, minimizing portfolio turnover, and leveraging advanced strategies like tax-loss harvesting to reduce taxes. The result is a lower capital gains tax bill when selling the fund and less tax on distributions.

#2. Minimize taxes with tax-coordinated accounts.

Investors can minimize their taxes by holding investments that generate taxable income, such as taxable bonds or high-turnover funds, in tax-deferred accounts. Meanwhile, you can hold tax-neutral investments in non-tax-deferred accounts, like a taxable brokerage account, since they don’t generate a high level of tax.

Free Worksheet: Organize Your Investments to Maximize Tax Efficiency

In addition, you can harvest tax losses by realizing them (e.g., selling) in taxable accounts and repurchasing similar assets in tax-advantaged accounts. That way, you can maintain an overall balanced portfolio while offsetting capital gains and up to $3,000 in regular income each tax year. This is especially useful for high-net-worth investors. But, be cautious of the wash-sale rule

#3. Diversify your account types to minimize taxes.

Contributions to Roth IRAs and Roth 401(k)s are made after-tax, providing you with tax-free growth over time. However, there are limits to these accounts and income thresholds to keep in mind. Meanwhile, traditional IRA and 401(k) contributions are pre-tax and reduce your current taxable income, which may be preferable if you’re in a high tax bracket.

You may need different accounts for different purposes in retirement. For instance, if you need taxable income in retirement to realize tax deductions, you can make just enough withdrawals from a traditional IRA or 401(k) and draw the rest from a Roth account. That way, you maximize your tax benefits and minimize your overall exposure.

#4. Try to hold investments over a long timeframe.

Qualified dividends require investors to own shares for at least 61 days during the 121-day period that begins 60 days before a company or fund declares dividends. At the same time, holding investments for more than a year means that you could realize lower long-term capital gains tax rates rather than paying higher short-term capital gains tax rates.

The Bottom Line

Investors are responsible for many different types of taxes on their investments. Having knowledge of these tax rates and the rules allows you to avoid making costly mistakes and maximize your after-tax returns.

If you’re interested in generating portfolio income, the Snider Investment Method makes it easy to generate an income from covered calls and cash-secured puts. That way, you can hold a long portfolio of stocks rather than buying fixed-income investments with significant interest rate risk associated with them.

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