Your guide to investment tax

Understanding your portfolio’s tax characteristics is a step toward more efficient investing.

Tags: Investments, Investing, Taxes
Published: November 06, 2019

As an investor, you’ve likely developed an investment strategy and worked hard to diversify your portfolio. You might have investment accounts, such as 401k plans, IRAs and HSAs, that are taxed based on how they’re funded and when you withdraw your money. You might also invest outside of those accounts with investment vehicles, such as stocks, bonds, mutual funds and exchange-traded funds, that go by a different set of tax rules based on the income they’ve earned.

 

With a variety of investment accounts and vehicles working for you, it can be challenging to keep track of their individual tax characteristics. Here’s a look at the implications, benefits and guidelines surrounding the tax treatment of some common investments. This is not an exhaustive list of investment accounts and vehicles, and it’s a good idea to talk to a tax professional about your specific situation. 

 

Fully taxable investment vehicles

These investment vehicles do not receive preferential tax treatment. You will pay taxes on the income you earn through interest, dividend distributions or capital gains. However, there are no limits on how much you can invest.

 

Stocks

Typically stock investors are taxed on distributions at their ordinary income tax rate.

If you sell your shares, you’re taxed on capital gains. The capital gains rate varies based on how long you’ve held the stock: 

  • For stock funds held for less than a year, you’ll pay a short-term capital gains rate that is generally the same as the rate on earned income.

  • For stock assets held for more than a year, you’ll incur a long-term capital gains rate that is based on your income bracket and capped at 20 percent.1

 

Bonds

Interest earned on bonds is taxed as ordinary income (with the exception of municipal bonds, as discussed below).2

 

Mutual funds

The types of tax you pay will vary depending on the type of mutual fund. Some mutual funds pay out distributions to investors that are taxed as ordinary income. However, you will be subject to capital gains tax when a fund sells securities that have increased in price.3

 

ETFs

Exchange-traded funds (ETFs) act similarly to mutual funds when it comes to taxes, but they are structured in a way that triggers few taxable events, which usually means fewer opportunities for capital gains tax.4

 

REITs

Real estate investment trusts (REITs) allow investors to earn returns on bundled pools of real estate investments. REIT distributions are taxed as ordinary income, but gains are taxed at the capital gains tax rate.5

 

Tax-advantaged investment vehicles

Municipal bond funds

Unlike investment accounts and investment vehicles, municipal bonds are an asset that can be purchased individually or included as a component of an ETF or mutual fund. By pooling multiple municipal bonds into a single fund, municipal bond funds allow you to invest in a variety of bonds.

 

Plus, municipal bonds are given preferential tax treatment. Municipal bond income is typically tax-free at the federal, state and local levels. Although these funds generally offer relatively modest returns, they can outperform taxable bond funds if you factor in the amount you’ll save on taxes.6

 

Tax-advantaged investment accounts

You make tax-free contributions and are taxed on funds you withdraw. These are also called tax-deferred accounts.

 

401(k) accounts

401(k) accounts are retirement savings plans sponsored by an employer. With 401(k) accounts, you can contribute pre-tax dollars on a regular basis. Then, in many cases, your employer will match up to a certain percentage of your contributions. In 2019, regulations allow you to contribute up to $19,000 each year.8

Taxation on 401(k) withdrawals are dependent on the investor’s age:

  • If you are over 59 ½, withdrawals are taxed as normal income, which depends on your tax bracket.

  • Withdrawals made before age 59 ½ may face an additional 10 percent penalty tax.

  • After age 72, you must begin withdrawing (known as a required minimum distribution, or RMD).

 

IRAs

Many investors who do not have access to a 401(k) account through their employer turn to traditional individual retirement accounts (IRAs). With traditional IRAs, you can contribute up to $6,000 each year. If you are 50 or older, you can contribute $7,000 per year.10   For traditional IRAs, you can withdraw penalty-free after age 59 ½, and you must begin withdrawing at age 72. Withdrawals are taxed as ordinary income, which depends on your tax bracket.

However, if you withdraw from an IRA before 59 ½, you will pay an additional 10 percent tax. An exception allows paying some expenses — such as your first home, higher education costs and certain medical expenditures — with IRA withdrawals without incurring the tax penalty.11

 

403(b) accounts

If you work for a public school or a tax-exempt 501(c)(3) nonprofit organization, your employer might offer to match contributions into a 403(b) account instead of a 401(k) account.

Similar rules and limitations apply: Contributions are made with pre-tax dollars and withdrawals are taxed. The maximum contribution is $19,000 per year, and you’ll face an additional 10 percent tax for withdrawals before age 59 ½.12   After age 72, you must begin making withdrawals.

 

Tax-free investment accounts

Most tax-free investments and accounts are funded or purchased with after-tax dollars. This means you’ll be taxed up front, rather than when you withdraw funds or earn returns.

 

Roth 401(k) accounts

Similar to their traditional 401(k) counterpart, Roth 401(k) accounts are employer-sponsored retirement savings accounts. Like Roth IRAs, Roth 401(k) accounts allow you to make after-tax contributions and withdraw funds tax-free.

There is no income limit barring participation in Roth 401(k) accounts. You can contribute up to $19,000 per year, the same amount as a traditional 401(k) account.8  Further, the same 401(k) withdrawal limits apply to Roth 401(k)s: You’ll face a tax penalty for withdrawals made before age 59 ½, and you must begin making required minimum distributions at age 72, unless you’re still working.13

 

Roth IRAs

Unlike traditional IRAs, contributions into Roth IRAs are made with after-tax dollars. Therefore, withdrawals are made tax-free.

The yearly contribution limit on a Roth IRA in 2019 is $6,000 ($7,000 if you’re over age 50). To invest in to a Roth IRA, your adjusted gross income (AGI) in 2019 must not exceed $137,000 as an individual or $203,000 as a couple filing jointly.14  As an added benefit, you don’t have to wait until age 59 ½ to withdraw contributions (not earnings) from a Roth IRA. After the age of 59 ½ you can make unlimited withdrawals as long as the account has been open for at least 5 years, and there are not RMD requirements at age 72.11

 

529 savings plan

With a 529 savings plan, you can invest portions of your after-tax income to pay for qualified education expenses without incurring a tax penalty upon withdrawal. Qualified expenses include tuition, fees, books, and room and board at elementary and secondary schools. However, you cannot withdraw more than $10,000 per year.15

 

HSAs

Similarly, a health savings account (HSA) offers tax-free withdrawals for expenses related to doctor visits, health screenings and other medical services. With HSAs, you can contribute up to $3,500 for an individual in pre-tax money per year ($4,500 if you’re 55 or older), and $7000 for a family in 2019.16

 

Fully taxable investment accounts

While tax-advantaged and tax-free investment accounts offer distinct advantages, some investors prefer the flexibility offered by fully taxable investment accounts. Plus, you won’t need to keep track of the regulations governing tax-advantaged and tax-free accounts. 

 

Money market accounts

Money market accounts (not to be confused with money market mutual funds) generally offer higher interest rates than savings accounts, and they’re FDIC-insured up to $250,000. Any interest you earn on the account is taxed as ordinary income and dependent on your tax bracket.

 

Tax-efficient investing

A balanced, diversified portfolio includes a combination of tax-advantaged, tax-free and fully taxable investment vehicles and investment accounts. Keep in mind the makeup of your portfolio affects your overall tax burden, so it’s important to consider the big picture.

 

Tax-efficient investing and saving can be complicated, but it boils down to a few key principles: 

  • Typically, you’ll want to hold on to investments as long as possible. When it comes to capital gains, for example, holdings kept longer than a year receive the preferential long-term capital gains rate. As a rule of thumb, remember that investments with longer horizons might help lower your tax bill.

  • Not all investments are created equally. Even assets within the same class — stocks, for example — can affect your taxes differently.

  • Think holistically about your taxes and plan ahead. If you’re withdrawing from a 401(k) or an IRA in retirement, the amount you withdraw could bump you into a higher tax bracket. In turn, this could increase your capital gains rate.17 However, if you were to withdraw the same amount over two years, you might stay locked in at a lower rate.

 

Again, these are not the only investment accounts or vehicles out there, and each investment account vehicle comes with its own tax rules so talk to a tax professional about your specific situation.

 

 

Taxes can affect all sorts of financial decisions. Learn how taxes might also affect your charitable donations.

 

 
1Capital Gains Tax.” Investopedia. January 31, 2019.
2How Mutual Funds Are Taxed in the U.S.” Investopedia. September 29, 2018.
3Mutual Fund.” Investopedia. June 25, 2019.
4Tax Efficiency Differences: ETFs vs. Mutual Funds.” Investopedia. July 2, 2019.
5The Basics of REIT Taxation.” Investopedia. May 5, 2019.
6Why Buy a Municipal Bond Fund?” The Balance, December 29, 2018.
7Tax Deferred.” Investopedia. April 28, 2018.
8401(k) contribution limit increases.” IRS.gov.
9401(k) Resource Guide.” IRS.gov.
10IRA FAQs – Contributions.” IRS.gov.
11Traditional IRA vs. Roth IRA.” RothIRA.com.
12Retirement Plan FAQs Regarding 403(b) Tax-Sheltered Annuity Plans.” IRS.gov.
13Roth Comparison Chart.” IRS.gov.
14Contribution Limits: IRAs vs. 401(k)s.” RothIRA.com.
15529 Plans: Questions and Answers.” IRS.gov.
162019 HAS Limits Rise, IRS Says.” SHRM.org.
177 Advantages of Investing in Taxable Accounts.” Nerdwallet. February 19, 2016.
 
 
Equity securities (stocks) are subject to stock market fluctuations that occur in response to economic and business developments.  Investments in fixed income securities (bonds) are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities.  Mutual fund investing involves risk and principal loss is possible. Investing in certain funds involves special risks, such as those related to investments in small- and mid-capitalization stocks, foreign, debt and high-yield securities and funds that focus their investments in a particular industry. Please refer to the fund prospectus for additional details pertaining to these risks.  Exchange-traded funds (ETFs) are baskets of securities that are traded on an exchange like individual stocks at negotiated prices and are not individually redeemable. ETFs are designed to generally track a market index and shares may trade at a premium or a discount to the net asset value of the underlying securities.  Investments in real estate securities or REITs can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults).  The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issues of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes.