Impact of taxes on investment returns

If you have a variety of investment accounts and vehicles working for you, it can be challenging to keep track of their individual tax characteristics.

Here’s a high-level look at how some common investment vehicles and accounts are taxed. This is not an exhaustive list and determining taxes on investments can be complex, so it’s a good idea to talk to a tax professional about your specific situation.

Fully taxable investment vehicles

These investment vehicles do not receive preferential tax treatment. You’ll pay taxes on the income you earn through interest, dividend distributions or capital gains. However, there are no limits on how much you can invest.

Stocks

Dividend distributions you receive from stocks are usually taxable, and the rate varies depending on the type of dividend:

• Nonqualified dividends are taxed at your ordinary income tax rate.
• Qualified dividends are taxed at a lower rate based on your taxable income and filing status and capped at 20%.¹ Factors that determine whether a dividend is qualified are the time you’ve owned the stock, country of origin and the type of distribution received.

If you sell your shares, you’re taxed on capital gains. The capital gains rate varies based on how long you’ve held the stock:

• With stocks held for less than a year, you’ll pay a short-term capital gains rate that is generally the same as your ordinary income tax rate.
• With stocks held for more than a year, you’ll incur a long-term capital gains rate that is based on your income tax bracket and capped at 20%.²

Bonds

Interest earned on bonds is taxed as ordinary income (with the exception of municipal bonds, as discussed below).

REITs

Real estate investment trusts (REITs) allow investors to earn returns on bundled pools of real estate investments. REIT distributions are taxed as ordinary income, but gains are taxed at the capital gains tax rate.

Mutual funds

Because mutual funds are made up of different investment securities, such as stocks and bonds, dividends and capital gains are based on how long a fund has held an individual investment in its portfolio rather than on how long you’ve owned shares of the mutual fund.

Mutual funds will generally pay distribution on accrued income whether dividend or interest, in the form of dividends. They may also pay a distribution for the capital gains incurred within the vehicle. These are taxed depending on type of investments that make up the mutual fund and the qualifications of the investment account and the investor.

When you sell your position, you’ll be taxed on the capital gains accrued in your holding.

If you have mutual funds in retirement accounts, such as a 401(k) or IRA, or in a college savings account, such as a 529 plan, you only pay taxes on money withdrawn from the account.

ETFs

Exchange-traded funds (ETFs) act similarly to mutual funds when it comes to taxes, but distributions are only accrued on dividend/interest income and not on capital gains due to way they’re structured. This can make some ETFs more tax-efficient than mutual funds.³

However, like mutual funds, when you sell your position, you’ll be taxed on the capital gains accrued in your holding.

Fully taxable investment accounts

While tax-advantaged and tax-free investment accounts offer distinct advantages, some investors prefer the flexibility of fully taxable investment accounts. Plus, you won’t need to keep track of the regulations governing tax-advantaged and tax-free accounts.

Money market accounts

Money market accounts generally offer higher interest rates than savings accounts (though may have a minimum balance requirement), and they’re FDIC-insured (at banks) or NCUA-insured (at credit unions) up to $250,000.

A financial institution invests the money in your account in short-term, low-risk, highly liquid assets which provides you with a prescribed rate of interest. Any interest accrued on the account is taxed as ordinary income and dependent on your tax bracket.

Tax-advantaged investment vehicles

Investments that are tax-exempt, tax-deferred or that offer other types of tax benefits are referred to as tax-advantaged.

Municipal bond funds

Municipal bonds are an asset that can be purchased individually or included as a part of an ETF or mutual fund. Pooling multiple municipal bonds into a single fund allows you to invest in a variety of bonds

Municipal bonds are generally tax exempt at the federal level, as well as the state and local level if you live in the state in which the bond was issued. However, if you purchase bonds issued in another state, you may be taxed on the interest income by your home state.⁴

Tax-advantaged investment accounts

You make tax-free contributions and are taxed on funds you withdraw. These are also called tax-deferred accounts.

401(k) accounts

401(k) accounts are retirement savings plans sponsored by an employer. With 401(k) accounts, you can contribute pre-tax dollars on a regular basis and, in many cases, your employer will match up to a certain percentage of your contributions. The annual contribution limit in 2023 is $22,500. If you’re 50 or older, you can contribute an additional $7,500 each year.

Taxation on 401(k) withdrawals are dependent on the investor’s age:

• If you’re over 59 ½, withdrawals are taxed as normal income, which depends on your tax bracket.
• Withdrawals made before age 59 ½ may face an additional 10% penalty tax.
• After age 73, you must begin withdrawing a required minimum distribution, or RMD.

Traditional IRAs

You can contribute up to $6,500 each year into a traditional individual retirement account, or IRA. If you’re 50 or older, you can contribute an additional $1,000 per year. You can withdraw penalty-free after age 59 ½, and you must begin withdrawing at age 73. Withdrawals are taxed as ordinary income, which depends on your tax bracket.

If you withdraw from an IRA before 59 ½, you may pay an additional 10% tax. An exception allows paying some expenses — such as your first home, higher education costs and certain medical expenditures — with IRA withdrawals without incurring the tax penalty.

403(b) accounts

If you work for a public school or a tax-exempt 501(c)(3) nonprofit organization, your employer might offer to match contributions into a 403(b) account instead of a 401(k) account.

Similar rules and limitations apply: Contributions are made with pre-tax dollars and withdrawals are taxed. The annual contribution limit in 2023 is $22,500, and you can contribute an additional $7,500 each year if you’re 50 or older. You’ll face an additional 10% tax for withdrawals before age 59 ½, and you must begin making withdrawals after age 73.

Tax-free investment accounts

Most tax-free investment accounts are funded or purchased with after-tax dollars. This means you’ll be taxed up front, rather than when you withdraw funds or earn returns.

Roth 401(k) accounts

Like their traditional 401(k) counterpart, Roth 401(k) accounts are employer-sponsored retirement savings accounts and allow you to make after-tax contributions and withdraw funds tax-free. Roth 401(k) plan participants can now choose to have after-tax employer matching contributions directed to their workplace accounts.

There is no income limit for participating in Roth 401(k) accounts. Contribution and withdrawal limits are the same as with a traditional 401(k) account.

Roth IRAs

Unlike traditional IRAs, contributions into Roth IRAs are made with after-tax dollars and withdrawals are made tax-free.

The current annual contribution limit is $6,500, plus an additional $1,000 you’re over age 50. However, there are income eligibility restrictions for contributing to a Roth IRA.⁵

You don’t have to wait until age 59 ½ to withdraw contributions (not earnings) from a Roth IRA. After the age of 59 ½ you can make unlimited withdrawals as long as the account has been open for at least 5 years. Additionally, there are no RMD requirements with a Roth IRA.

529 savings plan

With a 529 savings plan, you can invest after-tax income to pay for qualified education expenses without incurring a tax penalty upon withdrawal. Qualified K-12 and college expenses include tuition, fees, books, and room and board. Tax-free withdrawals are limited to $10,000 per year for K-12 students.

HSAs

Similarly, with a health savings account (HSA), you contribute pre-tax money and take it out tax-free to cover expenses related to doctor visits, health screenings and other medical services. The annual contribution limit for individuals in 2023 is $3,850 and $7,750 for families. Those over age 55 can contribute an additional $1,000 per year.

Tax-efficient investing

A balanced, diversified portfolio includes a combination of tax-advantaged, tax-free and fully taxable investment vehicles and investment accounts. Keep in mind the makeup of your portfolio affects your overall tax burden, so it’s important to consider the big picture.

Tax-efficient investing and saving can be complicated, but it boils down to a few key principles:

• Typically, you’ll want to hold on to investments as long as possible. When it comes to capital gains, for example, holdings kept longer than a year receive the preferential long-term capital gains rate. As a rule of thumb, remember that investments with longer horizons might help lower your tax bill.
• Not all investments are created equally. Even assets within the same class — stocks, for example — can affect your taxes differently.
• Think holistically about your taxes and plan ahead. If you’re withdrawing from a 401(k) or an IRA in retirement, the amount you withdraw could bump you into a higher tax bracket. In turn, this could increase your capital gains rate. If you were to withdraw the same amount over two years, you may stay locked in at a lower rate.

Again, these are not the only investment accounts or vehicles out there, and each investment account vehicle comes with its own tax rules. Talk with a financial or tax professional about your specific situation.

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