Investing & taxes: Understanding tax on dividends, interest & capital gains

Taxes may not be the most exciting aspect of investing, but it's important to understand the basics of how they impact your investment income.

How the money gained from your investments is taxed differs depending on what kind of income it is. Capital gains from selling stocks, for example, isn't the same as interest collected on bonds. How long you hold the investment can also affect how it's taxed.

When you know these differences, you know what to expect with investing and taxes. We'll go through some common situations and offer strategies for you to minimize your tax burden and make well-informed investment decisions.

In this article, we'll cover:

• Taxes on investment profits

  • Capital gains: Difference between short- & long-term
  • Capital losses: Understanding tax-loss harvesting & wash sales

• Taxes on investment earnings

  • Stocks
  • Bonds
  • Mutual funds

• Taxes on tax-advantaged investments

  • Retirement account taxation
  • Education & other account taxation
• How to strategize tax efficiency with asset allocation
• Take control of your investment taxes

Most investments—such as stocks, bonds, mutual funds and real estate—can generate capital gains and losses in the year you sell them, so this area of brokerage account taxation is a good place to start. (Note that profits in accounts like retirement or college savings are tax-advantaged, so they don't follow these rules; they'll be covered later.)

Capital gains occur when you sell an investment asset for more than its adjusted basis (the original purchase or acquisition value plus or minus certain expenses, credits and taxes).

These taxes are assessed differently depending on the length of time since you acquired the asset.

• Short-term capital gains. If you sell an investment for a profit and you held it for one year or less, the profit is considered a short-term capital gain. It's considered part of your ordinary income, so it's taxed at your ordinary income tax rate, which falls between 10% and 37% based on tax brackets as of 2024.
• Long-term capital gains. Profit on an investment sold that you held longer than one year is considered a long-term capital gain. These are taxed at lower rates than ordinary income, so it can be to your benefit to hold onto assets for more than a year when possible. There are exceptions for certain qualified stocks, collectibles and property, but generally, the rates as of 2024 are as follows:

Long-term capital gains tax rates

Short-term capital gains tax rates

Capital gains tax example

• Bailey, a single tax filer, invests $1,000 in a stock and later sells it for $1,500, making a profit of $500. Bailey's usual annual taxable income is around $50,000.
• Let's say Bailey sold the stock after 10 months. Bailey would get the short-term capital gains tax treatment:
  
  • $500 (profit) x 22% (tax rate) = $110
• Or, instead, let's say Bailey sold the stock after 16 months. Then Bailey would pay at the long-term capital gains rate:
  
  • $500 (profit) x 15% (tax rate) = $75

SPECIAL CONSIDERATION: When someone dies and leaves an asset to you that you later sell, calculating capital gains can get more complex. Capital gains taxes on inherited property have special rules involving a stepped-up basis that factors in the asset's fair market value when the person who left it to you died.

Investing isn't always about gains. Sometimes, your investments lose value. In these situations, the tax code can offer a silver lining: tax-loss harvesting.

When you sell an investment for a loss (you received less than the adjusted basis), you can claim that loss on your tax return. After netting capital losses against capital gains, up to $3,000 per year of additional losses can be used to offset ordinary income to potentially reduce your overall tax bill.

Tax loss harvesting example

• Bailey invests $1,000 in a mutual fund and later sells it at $700—a $300 loss.
• Bailey claims that $300 loss in order to reduce the capital gains taxes on other investments.
• As you may remember from the previous example, Bailey had a $500 capital gain from selling stock.
• Let's say Bailey had a short-term gain of $500 and a short-term loss of $300:
  
  • [$500 (profit) - $300 (loss)] x 22% (tax rate) = $44
• If Bailey had a long-term gain of $500 and a long-term loss of $300:
  
  • [$500 (profit) - $300 (loss)] x 15% (tax rate) = $30

One thing you have to beware of when selling at a loss, however, is a wash sale. This happens if you sell an investment for a loss and then repurchase the same or a substantially similar investment within a short period (typically 30 days before or after the sale). If you trigger a wash sale, the IRS disallows you from claiming the tax loss on the original sale.

Even if you don't have capital gains and losses because you aren't selling your invested assets, your investments can still earn investment income by accumulating interest or earning dividends. (Again, interest and dividends in tax-advantaged accounts don't follow these rules and will be covered in the next section.)

Understanding the taxation of different investment types is vital for effective financial planning and maximizing after-tax returns. Here's an overview of how stocks, bonds and mutual funds may be taxed for interest and dividends:

Taxation on stock earnings hinges on whether or not the company you hold shares with pays dividends. Some companies, mainly as a way of attracting more investors, will distribute a portion of their profit to shareholders. These dividends are usually paid quarterly, and they may be ordinary or qualified.

You'll know which it is based on the Form 1099-DIV issued by the company. The IRS says the dividend payer must identify the type.

Ordinary dividends are considered ordinary income and are taxed at the current rates for different tax brackets—between 10% and 37% as of 2024. Dividends from foreign equities and bond funds are generally classified as ordinary dividends. Qualified dividends, which are ones that meet IRS requirements to be taxed at the lower capital gains tax rates of 0%, 15% or 20% (see previous chart for details), are typically paid by stocks of U.S. companies.

Bond taxation is primarily generated from interest income and may vary depending on the type of bond you hold. For example, interest income from bonds is generally taxed at ordinary income tax rates. However, municipal bonds are generally exempt from federal income tax. They also may be exempt from state and local taxes if the investor lives in the issuing state. U.S. Treasury bonds are generally subject to federal income tax but exempt from state and local taxes.

Taxes on mutual funds are similar to stocks and bonds, with differences that depend on the type of mutual fund.

Like stocks, income from dividends and interest distributed by mutual funds is taxed according to the type of income, as determined by the company paying you (ordinary dividends, qualified dividends or interest). Income from municipal bond mutual funds is generally exempt from federal income tax, and income from U.S. Treasury bond funds is subject to federal income tax but exempt from state and local taxes.

Certain investments like retirement accounts and college savings plans come with tax advantages, so they're treated differently than other investments on purpose as an incentive to save for important things.

In the case of retirement savings—whether it's an employer-sponsored 401(k) or IRA, a self-employed retirement account or an IRA you opened on your own—you may have either a traditional or Roth version. This designation refers to how your contributions are taxed, how your earnings are taxed and how your withdrawals are taxed.

• Traditional. These accounts allow you to invest pre-tax money in your retirement account.
  
  • It's either directly diverted from your paycheck or you can take a tax deduction so that you're not paying income tax on it in the year it was contributed.
  • Any profit, earnings, interest or dividends generated by the investments are not taxed when they occur. Instead, all taxes are deferred until you make a withdrawal, at which time, any money you take out is taxed as ordinary income.
  • If you withdraw money before age 59½, you'll also face a 10% tax penalty on what you take unless you qualify for an exception, but after that age, the money is intended to be drawn from as your retirement income.
• Roth. This type of account is funded with after-tax dollars—money that's already been subjected to income taxes.
  
  • As with a traditional retirement savings account, the profit or earnings from the investments are not taxed when they occur.
  • You may be taxed on the profit or earnings at withdrawal unless your Roth IRA is at least five years old and: You are at least 59½, disabled, a first-time homebuyer ($10,000 lifetime maximum) or the money is being paid to a beneficiary.
  • If you don't meet the above requirements, you'll pay your current income tax rate on just the withdrawn earnings (not your contributions since you've already paid taxes on those), and you may be assessed a 10% tax penalty if you don't meet an exception.

Dive deeper into what you need to know about taxes in retirement

If you're saving for college or continuing education yourself or a loved one, you may have investments in a 529 college savings plan or Coverdell education savings. These are similar to Roth accounts where contributions are made with after-tax dollars and the account growth is not taxed unless you withdraw money for a use that doesn't qualify as an educational expense.

Asset allocation can be used as a tax-minimization strategy that involves placing investments in specific accounts based on their tax treatment. For example, investments that generate lower tax-deferred income (like tax-exempt municipal bonds) or qualified dividends (potentially taxed lower than ordinary income) might be suitable for taxable accounts. You'll pay taxes on the income generated but at potentially lower rates.

Investments that generate ordinary income (like taxable bonds or high-yield investments) might be better suited for tax-deferred accounts like traditional IRAs or 401(k)s. Contributions may be deductible or taken before tax, which is a tax break for these accounts, your earnings grow tax-deferred until withdrawal in retirement, potentially reducing your overall tax burden.

By strategically placing investments—and understanding the difference between regular brokerage account taxation and the tax benefits of retirement accounts—you can minimize the taxes you pay on your investment income, allowing more of your returns to work for you over time.

By familiarizing yourself with key concepts like capital gains rates, tax treatment of dividends and tax-advantaged accounts, you can make informed, tax-efficient decisions about your investments. This can help you have more money to put toward your financial goals.

Consulting with a Thrivent financial advisor can help you navigate the specifics of your portfolio and tailor an investment strategy with tax considerations and asset allocations that aim to maximize your long-term returns.