Investing isn’t all a swirl of accumulation and compounding securities, there’s another area that’s just as prevalent, and if not properly planned for, can cost you big—taxes. 

Your investments could be taxed in a myriad of ways depending on the asset itself, any produced income, your buying/selling habits, and how long you hold each investment. 

Let’s take a closer look at the most common types of taxes you’ll encounter in your investments, and how to strategically lower your bill. 

Income Producing Investments

Investing is a great way to keep your money working for you. It’s also important for long-term wealth accumulation, but the financial payouts of investing aren’t only reserved for the future. 

Some investments produce income like dividends or interest, both of which will be taxed.

How is interest taxed?

Interest, in general, is taxed as ordinary income. Some interest may be exempt from federal tax like municipal bonds (could still be subject to state tax) or exempt-interest mutual funds. Work with your financial advisor to better understand the type of investments, and the subsequent tax treatments, you have in your portfolio. 

How are dividends taxed?

Most dividends are taxable the year received. Many investors schedule their dividends to automatically reinvest in the fund, so are those still considered income? Yes. Any dividend, whether you take it as cash or reinvest it, must be reported as income to the IRS. Your custodian will send you a 1099-DIV that will clearly outline your produced income for the year. 

There are two general types of dividends, each with different tax consequences.

• Unqualified dividends (taxed as ordinary income)
• Qualified dividends (taxed at capital gains rate)

Tips to lower your tax bill for income-producing investments

If you have income-producing investments, it’s critical to build a plan that keeps the tax consequences in mind. Below are a few ideas to help you prepare. 

• Invest in funds that pay qualified dividends to take advantage of the lower capital gains tax rate.
• Hold your investments longer. Sometimes the longer you hold a security, the lower your tax liability.
• Put income-producing assets in tax-sheltered investment accounts like a 401(k) or traditional IRA. This way, you won’t have to pay taxes on the money until distribution in retirement.
• Prepare for your tax bill with a healthy cash reserve—this is true across the board. You always want to have a solid cash buffer to protect you. 

Capital Gains and Losses 

Many investors are familiar with capital gains tax. If you’ve ever sold a security for a profit, you’ve been exposed to capital gains tax. 

Capital gains tax applies to “capital assets” like stocks, bonds, and real estate. The tax is paid when the owner realizes the gain and sells the asset. The IRS taxes capital gains in two ways:

• Short-term capital gains
• Long-term capital gains

How are short-term capital gains taxed?

If you hold an asset for a year or less, then sell the asset for a profit, that’s considered a short-term capital gain. Short-term capital gains tax is often synonymous with your ordinary-income tax rate, making it far less favorable than its long-term counterpart.

How are long-term capital gains taxed?

Any asset held over one year is treated as long-term capital gains. The tax rate range is either 0%, 15%, or 20% depending on your income. Most investors fall into the 15-20% category.

Collective assets such as art, rare coins, and stamps carry a different capital gains treatment, which can be as high as 28%. 

Other tax consequences 

If your investment income and modified adjusted gross income surpass certain levels, you could be on the hook for an additional 3.8% net investment income tax (NIIT). For 2024, those filing single or head of household can’t exceed $200,000, and that increases to $250,000 for those married filing jointly. 

While NIIT doesn’t include your wages, it does consider your capital gains, dividends, interest, and rental income.

How to lower your capital gains tax liability

No matter how carefully you plan, you’ll have to pay capital gains tax at some point. But there are ways to strategically lower your tax bill. 

• Employ tax-loss harvesting when appropriate. This strategy allows you to offset capital gains with capital losses and/or deduct up to $3,000 of ordinary income. If your losses exceed the $3,000 ordinary income limit, you can carry the remaining balance forward and apply it to the next tax year. 
• Hold your assets long-term. Hanging onto your investments for just over a year can drastically reduce your tax bill. If you’re in the 37% tax bracket, for example, a long-term capital gains rate of 20% lowers your liability significantly.
• Build a strategic plan for rebalancing your portfolio. Every portfolio requires regular maintenance and staying on top of that can give your taxes some breathing room.  

Mutual Fund Taxes

You might be wondering, what makes mutual funds different from any other investment. Won’t you incur capital gains at the sale the same way you would with an ETF or other security? Unfortunately, the answer is no.

Taxes on mutual funds can get a little bit in the weeds, but in general, you could be responsible for the following while you still own the fund:

• Dividends 
• Interest
• Capital gains

It’s possible (and prevalent) for mutual funds to produce interest, dividends, and capital gains within the fund. The worst part? You don’t have control over when the capital gains will hit. This leaves many investors blindsided by huge tax blows. We think there is a better way to invest. 

Many investors benefit from investing in ETFs as opposed to mutual funds. 

Why can ETFs be more cost-effective? 

• First, they may have a lower minimum, opening up investment opportunities to a wider range of investors. 
• ETFs only require one transaction to buy and sell, which can reduce brokerage and commission costs. 
• Investors have more control over when capital gains are triggered, unlike with mutual funds.
• Many passively managed ETFs see lower overall investment costs.

We’ve seen so many people find greater confidence when investing in a low-cost, passively managed way. Do you know how your funds are managed? Let’s talk about it together.

Workplace Retirement Plan

For many, workplace contributions like in a 401(k) are made pre-tax. Funds grow in the account tax-free (making it a good place for income-producing investments as you wouldn’t have to pay taxes while housed in the account). You’ll be taxed at distribution. 

Distributions are considered ordinary income, which could produce several other tax consequences in retirement like an increased tax on Social Security benefits and Medicare premiums.

It’s important to have tax-diversity in your retirement plan a.k.a building a mix of pre-tax, post-tax, and taxable accounts. Having all of your assets tied into one type of account (notably pre-tax ones) doesn’t give you as much flexibility later on. It’s all about striking the right balance for you.

Sale on Your Home

You often have to pay capital gains on the sale of your house (if you earn a profit). The IRS does grant exclusions that can be really beneficial. If qualified, those who file single can deduct $250,000 of the gain and married filing jointly can exclude $500,000 of that gain.

To qualify for the exclusion, you must have used the home as your primary residence for at least 2 years in the 5 years before the sale. So if you’re selling in 2024, you must have used the home as your primary residence for at least two years between 2019-present. 

Say you and your spouse bought your house on Lake Fenton for $300,000 and sold it for $1 million. Filing your taxes jointly could shave $500,000 off your capital gains requirement, but in this scenario, you could still be on the hook for $200,000 in capital gains (the rate determined by your income and filing status).

Take Your Investment Strategy To The Next Level

As you can see, investments aren’t one-dimensional. Several layers work together, and it’s critical to be intentional about each step. 

We love working with families to build a comprehensive investment plan that combines high-level factors like risk preferences, time horizon, and goals and granular factors like allocations and tax-efficiency. 

If you’d like to talk more about an investment strategy that meets your needs, give us a call to get started with our team.

Advisory services are offered through Legacy Wealth Advisors, LLC dba Legacy Wealth Advisors, an Investment Advisor in the State of Michigan. The information contained herein should in no way be construed or interpreted as a solicitation to sell or offer to sell advisory services to any residents of any State other than the State of Michigan or where otherwise legally permitted.

All content is for information purposes only. It is not intended to provide any tax or legal advice or provide the basis for any financial decisions. Nor is it intended to be a projection of current or future performance or indication of future results. Moreover, this material has been derived from sources believed to be reliable but is not guaranteed as to accuracy and completeness and does not purport to be a complete analysis of the materials discussed. Legacy Wealth Advisors does not offer tax planning or legal services but may provide references to tax services or legal providers. Legacy Wealth Advisors may also work with your attorney or independent tax or legal counsel. Please consult a qualified professional for assistance with these matters.