How are my investments taxed?

It’s officially tax season, which means your mailbox is probably full of envelopes marked “Important tax documents enclosed.” With so many documents to sort through such as W-2s, 1098s and various 1099s, it can be overwhelming to understand what each form is and what it means. It’s important not only to understand the different types of taxes your investments may be subject to, but also to identify opportunities to potentially reduce your future tax burden. Below, we outline three main types of investment taxes.  

Interest income and how it’s taxed

What it is: Interest income is the income a taxpayer receives from certain types of accounts or for lending money to someone else. The most common accounts and investments that produce interest income include (but are not limited to):

• Interest on checking and savings accounts and certificates of deposit (CDs)
• Interest on fixed-income investments, such as Treasury, corporate and municipal bonds

How it is taxed: At the federal level, interest is taxed as ordinary income, subject to your marginal tax rate, while at the state level, it is subject to the rules imposed by that jurisdiction. Notably, there are some differences depending on the type of investment. For example, Treasury notes/bonds are not taxed at the state level, while municipal bonds are not taxed at the federal level (although they may be at the state level and may even be subject to the alternative minimum tax [AMT]).

Dividends and how they’re taxed

What they are: A dividend is a form of distribution by a company to its shareholders, typically in the form of cash. While often paid out quarterly, dividends can be paid out annually or monthly. Dividends are not required by companies, and many choose not to issue dividends at all.

How they are taxed: Dividends are taxed according to their classification of ordinary (nonqualified) or qualified. Ordinary dividends are taxed as ordinary income, subject to your federal marginal tax rate, whereas qualified dividends are taxed according to your capital gains tax rate. The determination of a dividend’s tax status is based on the holding period and type of investment. To be considered qualified, the rule is a bit technical: the dividend received must be distributed by a U.S. or qualifying foreign company and must be from stock you owned for more than 60 days out of a 121-day period, which begins 60 days before the stock’s ex-dividend date. Note that certain dividends, such as those from real estate investment trusts (REITs) and master limited partnerships (MLPs), are specifically excluded and are considered nonqualified.

Reinvested dividends

Investors may also reinvest dividends received to purchase additional shares (or fractions of a share). Reinvested dividends are considered taxable and can be either ordinary or qualified.

Capital gains and how they’re taxed

What they are: A capital gain or loss is generally the difference between the proceeds received from the sale of an investment and the investment’s cost basis. The cost basis represents the amount you paid for an investment over time, including the original purchase price, commissions and fees, adjusted for items such as reinvestments, capital distributions and corporate actions. In general, if the investment increases in value over the time you own it, you may have a capital gain. Conversely, if the investment’s value decreases over the time you own it, you may have a capital loss. Capital gains can also be realized in the form of a mutual fund long-term capital gain distribution, meaning you could have capital gains even if you didn’t sell the fund. These distributions represent your portion of capital gains from investment sales within a mutual fund portfolio. This is why you could have capital gains in years when you don’t personally sell mutual fund shares or in years when your portfolio decreases in value.

How they are taxed: Depending on the holding period and type of investment, your capital gains or losses will be classified as either long-term or short-term, which will determine how they are taxed. In general, capital gains are classified as long term if you hold the investment for more than one year, receive a mutual fund capital gain distribution or inherited the investment. Capital gains are classified as short term if they are held for one year or less. When included on your tax return, capital gains are netted together, which can result in one of the following: 

A) The combined amounts represent a loss: Up to $3,000 can be used to offset ordinary income, with the remainder being carried forward into future years. 
B) The combined amount represents a net short-term capital gain: This is taxed as ordinary income, subject to your individual marginal tax rate.
C) The combined amount represents a net long-term capital gain: This will be applied to your long-term capital gains rate, which is determined based on your taxable income.

Where do I find my investment income?

An investment’s interest and dividend income (as well as the related tax status), sale proceeds and adjusted cost basis are generally displayed on various Form 1099s. If your investments are located at a brokerage firm (such as Edward Jones), you may receive a consolidated Form 1099 combining various 1099 forms in one document. Consolidated Form 1099s issued by Edward Jones are made available to you by Feb. 15, as required by the IRS.

What if my capital gains or income is too high? What is the NIIT?

If your modified adjusted gross income (MAGI) exceeds certain thresholds (see below for thresholds by filing status), you may be subject to the net investment income tax (NIIT) and required to file Form 8960. NIIT is an additional 3.8% tax applied to certain net investment income including, but not limited to, interest (unless tax-exempt), dividends, passive ownership in businesses involved in the trading of financial instruments or commodities, and taxable net capital gains.

Opportunities to manage your taxes

As you go through your tax return, you may find that your investment income is being taxed more than you hoped. Particularly for tax year 2023, interest income may be higher than expected based on higher interest rates. Similarly, your net capital gains may have been surprisingly high. But how do you manage this going forward? Here are a few ways that can help reduce the tax burden on your investments:

• For interest income: Depending on your tax rate, it might make sense to consider investing in municipal bonds since their interest is not subject to federal — and potentially state — tax, avoid placing tax-advantaged investments like municipal bonds in tax-deferred accounts.
• For dividends and capital gains: Consider avoiding high turnover in taxable accounts by holding investments longer term instead of buying and selling frequently. This will help classify dividends as qualified instead of ordinary while helping minimize taxation by qualifying capital gains as long term instead of short term.
• For capital gains: Consider reducing net capital gains through tax-loss harvesting. This is when you sell some of your investments at a loss to offset current or future capital gains. Note that losses are subject to “wash-sale” limitations whereby a loss can be disallowed if you (or your spouse) buy or sell “substantially identical” security within 30 days before or after the sale.

Stay informed

Understanding the tax implications of your investments can be challenging. If you’re not careful, taxes can gradually erode your investment returns. That’s why it becomes even more important to stay informed. We recommend working with your financial advisor and tax professional to manage your investments in a tax-efficient manner to make this process as simple as possible.

Edward Jones, its employees and financial advisors cannot provide tax or legal advice. You should consult your attorney or qualified tax advisor regarding your situation.