Investment and Tax: What You Need to Know

Engaging with the investment world requires an understanding that financial growth and tax responsibilities are closely linked. Nearly every action taken with an investment, from buying and holding to selling, can generate a tax event. By understanding how investment returns are taxed, individuals can make more informed choices that align with their financial objectives.

Understanding Tax on Investment Income

The profits generated from your investments are generally subject to taxation, but the specific treatment depends on the nature of the income. The three primary forms of investment income are capital gains, dividends, and interest, each with its own set of rules and tax rates. The tax system treats these various types of investment returns differently, resulting in a tiered system where some income is taxed at preferential rates.

Capital Gains

A capital gain is the profit realized from the sale of a capital asset, such as stocks, bonds, or real estate. The gain is calculated as the difference between the sale price and the asset’s “basis,” which is the original purchase price. The tax treatment of these gains hinges on how long you owned the asset before selling it, which determines if the gain is short-term or long-term.

Gains from assets held for one year or less are considered short-term capital gains and are taxed at your ordinary income tax rates. Profits from assets held for more than one year are classified as long-term capital gains and receive more favorable tax treatment. For the 2025 tax year, long-term capital gains are taxed at rates of 0%, 15%, or 20%.

For a single filer, the 0% rate applies to taxable income up to $48,350. The 15% rate applies to income between $48,351 and $533,400, and the 20% rate applies to income above that threshold.

Dividends

Dividends are distributions of a company’s earnings to its shareholders. The tax you pay on this income depends on whether the dividends are classified as “qualified” or “non-qualified” (ordinary). This distinction determines if the income is taxed at preferential long-term capital gains rates or at higher ordinary income rates.

To be considered a qualified dividend, the dividend must be paid by a U.S. corporation or a qualified foreign corporation, and you must satisfy a holding period requirement. For common stock, you must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the cutoff day for being entitled to the upcoming dividend payment.

Qualified dividends are taxed at the same favorable rates as long-term capital gains: 0%, 15%, or 20%, depending on your taxable income. Non-qualified dividends, which fail to meet the requirements, are taxed at your regular ordinary income tax rates. This category includes payments from certain tax-exempt organizations and dividends on deposits in credit unions, which are technically considered interest.

Interest Income

Interest income is what you earn from lending your money through investments like corporate bonds, certificates of deposit (CDs), and savings accounts. Most interest income is considered ordinary income and is taxed at your standard federal income tax rate. Financial institutions report this income to you and the IRS on Form 1099-INT if you earn $10 or more.

Even if interest is not withdrawn and is instead reinvested, it is taxable in the year it is credited to you. Interest earned on U.S. Treasury bills, notes, and bonds is subject to federal income tax but is exempt from state and local income taxes.

A notable exception is the interest generated by municipal bonds, which are debt securities issued by states, cities, or other local government entities. The interest income from municipal bonds is exempt from federal income tax. If you reside in the state that issued the bond, the interest may also be exempt from state and local taxes.

Tax Implications of Different Investment Accounts

Where you hold your investments is as important as what you invest in, as the type of account determines how and when your earnings are taxed. Investment accounts can be broadly categorized as taxable, tax-deferred, and tax-exempt. Choosing the right account can influence your long-term returns by altering the tax drag on your portfolio’s growth.

Taxable Brokerage Accounts

A standard taxable brokerage account offers the most flexibility but the fewest tax advantages. You contribute money that has already been taxed (after-tax dollars), and there are no annual contribution limits. You have freedom to invest in a wide range of assets like stocks, bonds, mutual funds, and ETFs.

The primary tax feature of a taxable account is that investment income is taxed on an ongoing basis. Any dividends or interest you receive are taxable in the year they are paid. When you sell an asset for a profit, you realize a capital gain, which is also taxed in that year. Withdrawals of your original contributions are not taxed, as the account was funded with after-tax money.

Tax-Deferred Accounts

Tax-deferred accounts, such as a traditional Individual Retirement Arrangement (IRA) and a traditional 401(k), offer a different timing for tax benefits. Contributions to these accounts may be tax-deductible in the year they are made, which lowers your current taxable income.

Inside a tax-deferred account, your investments grow without being taxed annually on capital gains, dividends, or interest. This tax-deferred growth allows your earnings to compound more rapidly over time compared to a taxable account.

The tax liability is realized upon withdrawal. When you take money out of a traditional IRA or 401(k) in retirement, the distributions are taxed as ordinary income. This applies to both your original contributions (if deducted) and all investment earnings. Withdrawals before age 59½ may also be subject to a 10% penalty in addition to income tax.

Tax-Exempt/Tax-Free Accounts

Tax-exempt accounts, most notably the Roth IRA and Roth 401(k), reverse the tax structure of their traditional counterparts. Contributions to Roth accounts are made with after-tax dollars, meaning you do not receive an upfront tax deduction. The primary advantage is realized in the future.

All investment growth within a Roth account is completely tax-free. As your investments generate capital gains, dividends, and interest, no taxes are due. This allows your portfolio to grow unhindered by annual tax obligations.

The payoff comes during retirement, as qualified withdrawals from a Roth IRA or Roth 401(k) are entirely tax-free. To be considered qualified, the account must be open for at least five years, and you must be age 59½ or older. This provides a source of retirement income that is not subject to federal income tax.

Health Savings Accounts

A Health Savings Account (HSA) offers a unique combination of tax benefits, often referred to as being “triple-tax-advantaged.” To be eligible to contribute to an HSA, you must be enrolled in a high-deductible health plan (HDHP). While designed for healthcare costs, HSAs can also function as a supplemental retirement savings vehicle.

The first tax advantage is that contributions are tax-deductible. The second benefit is that the funds within the HSA can be invested and grow completely tax-free. The third advantage is that withdrawals are also tax-free, provided the money is used for qualified medical expenses.

Funds in an HSA roll over year after year if not spent, allowing the balance to grow. After age 65, you can withdraw money from an HSA for any reason without a penalty. If the withdrawal is not for a qualified medical expense, it will be taxed as ordinary income, similar to a traditional IRA distribution.

Calculating and Reporting Investment Taxes

Managing your investment portfolio includes accurately calculating and reporting your tax obligations to the IRS. This process involves tracking the original cost of your assets, understanding the informational forms from your financial institutions, and correctly using the required IRS schedules to report your activity.

Cost Basis

The cost basis of an asset is its original value for tax purposes and is the foundation for calculating capital gains or losses. For a stock, the basis is the purchase price plus any commissions or fees paid. When you sell the asset, the taxable gain or loss is determined by subtracting the cost basis from the sale price.

The calculation can become more complex if you acquire shares of the same security at different times and prices. When you sell a portion of these shares, you may be able to choose which lot to sell. Common methods for determining basis include “first-in, first-out” (FIFO) or the “average cost” method, which is often used for mutual funds.

Adjustments to basis can occur over the life of an investment. For example, if you reinvest dividends to buy more shares, the amount of the reinvested dividend is added to your cost basis. Corporate actions like stock splits also require basis adjustments, making it important to keep records of all transactions.

Key Tax Forms

Financial institutions issue informational returns, known as the Form 1099 series, to both you and the IRS. These forms report the various types of investment income you received during the year.

• Form 1099-INT details interest income.
• Form 1099-DIV reports dividends and capital gains distributions.
• Form 1099-B provides details on proceeds from security sales, including the cost basis.

The information from Form 1099-B is used to complete Form 8949, Sales and Other Dispositions of Capital Assets. On this form, you list the details of each asset sale, reconciling the information from your 1099-B with your own records and making any necessary adjustments to the cost basis.

The subtotals from Form 8949 are then transferred to Schedule D, Capital Gains and Losses. Schedule D summarizes all your capital gain and loss activity for the year. It separates short-term and long-term transactions and calculates your net capital gain or loss, which is then carried over to your main Form 1040 tax return.

Net Investment Income Tax

For individuals with income above certain levels, an additional tax may apply to their investment earnings. The Net Investment Income Tax (NIIT) is a 3.8% tax levied on the lesser of your net investment income or the amount by which your modified adjusted gross income (MAGI) exceeds specific thresholds. The thresholds are $200,000 for single filers and $250,000 for those married filing jointly.

Net investment income subject to the NIIT includes interest, dividends, capital gains, rental and royalty income, and passive business income. It does not include wages, distributions from retirement accounts like 401(k)s and traditional IRAs, or Social Security benefits. However, income from these non-investment sources does count toward the MAGI threshold that determines if the tax applies.

The NIIT is calculated on Form 8960, Net Investment Income Tax. For example, if a single filer has a MAGI of $240,000 and $50,000 of net investment income, their MAGI exceeds the $200,000 threshold by $40,000. The 3.8% tax would apply to the lesser of the excess MAGI ($40,000) or the net investment income ($50,000), resulting in an NIIT of $1,520.

Key Tax Rules and Concepts for Investors

Beyond the foundational principles of how investment income and accounts are taxed, several specific rules can impact an investor’s tax liability. These concepts include strategies for managing capital gains and losses, limitations to prevent abuse of tax benefits, and the distinct tax treatments for assets transferred through inheritance versus gifting.

Tax-Loss Harvesting

Tax-loss harvesting is a strategy that involves selling investments at a loss to offset capital gains realized from the sale of profitable investments. By realizing a loss, you can reduce the amount of taxable gains you have to report, thereby lowering your tax bill. This technique is only applicable in taxable investment accounts, as there is no tax benefit to realizing losses within tax-advantaged retirement accounts.

The process follows a specific order. Short-term losses are first used to offset short-term gains, and long-term losses are used to offset long-term gains. If there are any remaining net losses in one category, they can be used to offset gains in the other category.

If your total capital losses exceed your total capital gains for the year, you can use up to $3,000 of the excess loss to deduct against your ordinary income ($1,500 for married filing separately). Any net capital loss greater than this limit is not lost; it can be carried forward to future tax years to offset gains or income.

The Wash Sale Rule

The wash sale rule limits the ability to claim a loss from selling a security. This IRS regulation prevents an investor from deducting a capital loss on a sale if they purchase the same or a “substantially identical” security within a 61-day window. This window includes the 30 days before the sale, the day of the sale, and the 30 days after the sale.

The rule’s purpose is to stop investors from generating a tax loss while maintaining their economic position in the investment. The rule applies across all of an individual’s accounts, including IRAs, and even extends to accounts held by a spouse. For example, selling a stock at a loss in a taxable account and then buying it back two weeks later in your IRA would trigger the wash sale rule.

When a loss is disallowed due to the wash sale rule, it is not permanently lost. Instead, the amount of the disallowed loss is added to the cost basis of the new, replacement security. This adjustment defers the tax benefit of the loss until the replacement security is sold.

Tax Treatment of Inherited and Gifted Assets

The way you acquire an asset—either as an inheritance or as a gift—determines its cost basis and has significant tax implications when you eventually sell it. The rules for these two types of transfers are distinct and can lead to very different tax outcomes for the recipient.

When you inherit an asset from someone who has passed away, the asset’s cost basis is adjusted to its fair market value on the date of the original owner’s death. This is known as a “step-up in basis.” This rule can provide a substantial tax benefit, as it often eliminates the capital gains tax on all the appreciation that occurred during the decedent’s lifetime.

In contrast, when you receive an asset as a gift during the giver’s lifetime, you also receive the giver’s original cost basis. This is known as a “carryover basis.” The recipient is responsible for the capital gains tax on all the appreciation since the asset was first purchased by the donor. If a stock worth $150,000 was gifted, the recipient’s cost basis would be the original purchase price, creating a large potential taxable gain upon its sale.