How Investment Income Is Taxed

Unless you sold other investments at a loss to balance the profit, you may have to pay taxes if you sold stocks for a profit in 2023. It can be difficult to determine how much of your investment income is taxable in either scenario and how it will be taxed.

Recognizing Taxes on Investment Income and Capital Gains

Subtract the original purchase price from your sales price to see if you have a capital gain. For tax reasons, the ensuing gain is reported as income, according to David Blain, CEO of BlueSky Wealth Advisors, located in New Bern, North Carolina.

There are two categories for capital gains: long term and short term. The tax rate on short-term capital gains is equal to your regular income tax rate. When you sell an investment that you have owned for more than a year at a profit, you are entitled to a long-term capital gain. Given that long-term capital gains are taxed at more advantageous rates than short-term capital gains, this is advantageous.

Depending on your taxable income, long-term capital gains taxes in 2023 can be anywhere from 0% and 20%. The majority of people should budget 15%. When the Tax Cuts and Jobs Act’s provisions expire on December 31, 2025, these rates, however, might alter.

Through tax-loss harvesting, you can use the sale of other investments at a loss to offset your long-term capital gains. Capital losses above capital gains are deductible by an individual taxpayer against ordinary income up to a maximum of $3,000 per year. The balance is carried over to counteract the gains in the following year.

Bond, money market fund, and certificate of deposit interest is likewise subject to ordinary income tax. Up to 37% can be the ordinary marginal income tax rate.

“Don’t forget state taxes, since each state has its own tax laws,” Blain says. “Some have capital gains tax, and some tax it as ordinary income.”

When investors sell stocks that paid dividends, they are responsible for paying taxes on the income they got from the sales of those stocks during their ownership. “Interest income is taxed at your ordinary income tax bracket, ranging from 12% up to 37% federal tax,” says Blain.

He continues, saying, “Some states tax interest income up to 13.3%.” Remember state taxes once more.

Forms for investment income are available for download from brokerage firms for investors. Businesses utilize IRS form 1099-B to record capital gains or losses. Distributions of capital gains and dividend income are reported on IRS Form 1099-DIV. Interest income is to be reported on IRS Form 1099-INT. A Composite 1099 form that combines the three of these is provided by certain brokers.

Investors report various sorts of investment income using Schedule D, sometimes referred to as Form 1040, even though brokers are obligated to provide these forms to investors.

Taxes May Apply to Withdrawals From Tax-Deferred Accounts

While tax-deferred accounts, like 401(k)s, IRAs, and health savings accounts (HSAs), are well-known for their tax advantages due to the fact that profits are not subject to annual taxes, these funds aren’t perpetually tax-free.

“When you take money out, you pay ordinary income tax on the amount of money you withdraw from the account,” Blain says. You don’t have to take any money out of retirement accounts until you are 72 years of age (or 73 if you turned 72 after Dec. 31, 2022). And thanks to the Secure Act 2.0, the required minimum distribution, or RMD, age will increase to age 75 in 2033.

The Roth IRA is an exception to these RMDs. “Roth IRA distributions are tax-free, and there is no required date to take any money out,” according to him. This is so because after-tax money is used to fund Roth IRAs.

Put another way, if you follow its rules, the IRS lets you keep everything else in your pocket since it has already received its piece. The following are these guidelines:

• Contributions made to a Roth IRA are tax- and penalty-free to withdraw at any age.
• As long as the account is at least five years old, Roth IRA earnings can be withdrawn beyond age 59 1/2 without incurring taxes or penalties.

There are other ways to make money that is tax-free than Roth IRAs. Municipal bond interest, which is typically free from federal taxes and can also be free from state and local taxes if you reside in the state where the bond is issued, is another example of income that is not subject to taxes. In contrast, interest earned on U.S. Treasury securities is typically not subject to federal taxes but is state tax exempt.

Get Ready for Distributions from Mutual Funds

With mutual funds, capital gains taxes might become more burdensome. When managers of mutual funds sell fund assets at a profit, the IRS views this gain as income that is distributed to fund investors. At the end of each calendar year, these distributions are reported to you on Form 1099-DIV.

“The mutual fund manager has discretion on when to buy and sell securities within the fund, and you as the investor are responsible for any associated capital gains,” says Michael Berkhahn, a certified financial planner and vice president with Graham Capital Wealth Management. This lack of control on the investor’s part and fact that these distributions may not come until December, make planning for mutual fund taxes challenging.

“The fluctuating capital gains each year adds an element of unpredictability to an investor’s annual tax planning, which can be particularly frustrating,” Berkhahn says. “This is why for higher income earners, it becomes imperative for investors to weigh these tax ramifications carefully before deciding on if mutual funds should be a part of their investment strategy.”

Know the Impact of Federal Taxes

If you buy and sell stocks often, it’s a good idea to set aside a small amount of money each month to help reduce the sticker shock of the federal tax implications.

“Most people are not great savers,” says Steve Wittenberg, director of legacy planning at SEI. “It takes discipline to set aside money on a consistent basis for any purpose, especially taxes. The tax bill can become daunting when it comes to investing and making significant nonwage income.”

According to him, a lot of wealth consultants would assist their customers in setting aside money in a liquid or low-risk account in case their tax obligations increase. “This way, cash will be on hand when the IRS comes knocking,” he says.

A few strategies can be used by investors to plan ahead and determine how much they should try to preserve. According to Wittenberg, some people use the previous year’s tax return as a reference, particularly if they anticipate continuous investment income.

“If your tax situation is more complex and particularly inconsistent, it is highly recommended that a tax preparer provide one or more tax projections to calculate the amount of tax that may be due,” Wittenberg says.

According to him, a lot of investors have to register quarterly payments in order to pay their taxes on time and prevent underpayment penalties.

Experts advise taxpayers to apply online for an installment agreement or file IRS Form 9465 if the amount owed is less than $50,000.

According to Blain, the stock should ultimately be the deciding factor when making investments, not the tax. “I’ve seen people refuse to sell something because they didn’t want to pay the tax, or alternatively, trade too often and lose a good percentage of their gains to taxation.”