Taxes on Investments: The Basics

Taxes can take a real bite out of investment returns, but the basic rules for U.S. investors are straightforward. What follows is a general overview of federal rules for taxable brokerage accounts. State taxes vary, and your situation may involve exceptions, so check the IRS guidance linked below or a tax professional.

Capital gains and losses

When you sell an investment for more than your cost basis (generally what you paid, including fees), the profit is a capital gain. Sell for less and you have a capital loss. Nothing is taxed while you simply hold an investment, even if its value rises.

  • Short-term: investments held one year or less. Gains are taxed at your ordinary income tax rate.
  • Long-term: investments held more than one year. Gains are taxed at lower rates of 0%, 15% or 20%, depending on your taxable income.

Holding a winning investment a little longer to cross the one-year mark can make a meaningful difference.

Using losses

Capital losses first offset capital gains. If losses exceed gains, you can deduct up to $3,000 of the excess against other income each year ($1,500 if married filing separately), and carry any remaining loss forward to future years. Selling losing positions on purpose to use this rule is called tax-loss harvesting.

The wash sale rule

If you sell an investment at a loss and buy the same or a substantially identical investment within 30 days before or after the sale, the loss is disallowed for now. It is added to the cost basis of the new shares instead. This rule applies across your accounts, including purchases in an IRA.

Dividends and interest

  • Qualified dividends are taxed at long-term capital gains rates.
  • Ordinary dividends and most interest are taxed as ordinary income.
  • Interest from U.S. Treasury securities is exempt from state and local income tax. Interest from many municipal bonds is exempt from federal income tax.
  • Mutual funds and ETFs pass through dividends and capital gains distributions, which are taxable to you even if you reinvest them.

Net investment income tax (NIIT)

The net investment income tax is a 3.8% federal surtax that came in with the Affordable Care Act, signed into law under President Obama. It is often described as a tax on gains over $200,000, but that is not quite how it works. The $200,000 test is on your income, specifically your modified adjusted gross income (MAGI), not on your gains alone.

The 3.8% applies to the lesser of your net investment income or the amount by which your MAGI exceeds the threshold for your filing status:

  • Single or head of household: $200,000
  • Married filing jointly or qualifying surviving spouse: $250,000
  • Married filing separately: $125,000

These thresholds are not indexed for inflation, so more investors cross them over time. For example, a single filer with MAGI of $230,000 that includes $50,000 of investment income owes the tax on $30,000, the amount over the threshold, which comes to $1,140.

Net investment income generally includes capital gains, dividends, interest, rental and royalty income, and income from businesses that are passive activities for you. It does not include wages, or distributions from IRAs, 401(k)s and similar retirement plans. Gain on the sale of your main home that is covered by the home sale exclusion is not included either.

The tax is figured on Form 8960 and filed with your return. Because it stacks on top of the regular 20% top rate for long-term capital gains and qualified dividends, the top federal rate on those can reach 23.8%.

Other rules to know

  • Collectibles: long-term gains on collectibles, including most gold and silver coins and bullion, can be taxed at up to 28%.
  • Inherited investments generally get a cost basis equal to their value at the owner's death, while gifted investments generally keep the giver's basis.

Paperwork

Your broker sends Form 1099-B for sales, 1099-DIV for dividends and 1099-INT for interest. Sales are reported on Form 8949 and Schedule D. Brokers track cost basis for most investments bought in recent years, but it is worth keeping your own records too.

Tax-advantaged accounts

Inside a 401(k), traditional IRA or Roth IRA, trades, dividends and interest are not taxed each year. Taxes depend on the account type when you withdraw. See Retirement Accounts.

Sources

Educational information. This page explains general concepts and is not investment, tax or legal advice. Rules, limits and fees are set by regulators and firms and can change, so confirm the details with the official sources listed before you act.
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