Investing outside of retirement accounts offers flexibility and potential growth, but it also comes with tax implications that can impact your overall returns.

Unlike tax-advantaged accounts such as 401(k)s or IRAs, non-retirement investment accounts don’t provide built-in tax deferrals, meaning the IRS takes a closer look at any income generated. Understanding how different types of investment income are taxed can help you make informed decisions about your portfolio.

Qualified Dividends and Long-Term Capital Gains: Favorable Tax Treatment

Stocks often generate income through dividends, which are payments made by companies to shareholders. Not all dividends are taxed the same way—some are considered qualified dividends, while others are ordinary (nonqualified) dividends.

Qualified dividends are paid by U.S. corporations or certain foreign companies and meet specific IRS holding period requirements. They are taxed at the more favorable long-term capital gains rates, which range from 0% to 20%, depending on your income level. This is significantly lower than ordinary income tax rates.
Nonqualified dividends, on the other hand, are taxed at your ordinary income tax rate, which can be as high as 37% for high earners.

Similarly, when you sell an investment for a profit, the tax rate depends on how long you’ve held it:

Short-term capital gains (assets held for one year or less) are taxed as ordinary income.
Long-term capital gains (assets held for more than one year) benefit from preferential tax rates, just like qualified dividends.

Because of this difference, investors often aim to hold onto stocks for more than a year to take advantage of the lower tax rates on long-term capital gains.

Taxable Bonds: Ordinary Income Tax Rates Apply

Unlike stocks, the majority of the return generated on bond investments come from the interest payments on those bonds, and less so from capital gains.

Corporate bonds pay interest that is fully taxable at ordinary income tax rates. Since these rates can be high, bond interest may create a larger tax burden than stock dividends.
U.S. Treasury bonds are exempt from state and local taxes but are still subject to federal income tax.
Municipal bonds (munis), issued by state and local governments, have a unique tax advantage: Their interest is generally federally tax-free. If you buy muni bonds issued in your home state, they may also be exempt from state income taxes, making them attractive for high-income earners in states with high tax rates.

Investors looking for stable income with tax efficiency often consider municipal bonds, but it’s important to compare their after-tax yield with taxable bonds to determine which offers the best return.

Tax Planning Strategies for Investment Income

Because tax rates vary depending on the type of investment income, a well-structured portfolio can help minimize taxes while maximizing returns. Some key strategies include:

Holding investments for the long term to take advantage of lower capital gains tax rates.
Placing high-tax investments in tax-advantaged accounts, such as IRAs or 401(k)s, to defer taxes on bond interest or nonqualified dividends.
Using municipal bonds for tax efficiency, especially if you’re in a high tax bracket.
Tax-loss harvesting, which involves selling underperforming investments to offset taxable gains.

Navigating Tax Complexity with a Fiduciary Financial Advisor

Understanding how different types of investment income are taxed is essential for making informed financial decisions. The right tax strategy can help you keep more of what you earn, but tax laws are complex and constantly evolving. A fiduciary financial advisor can help you analyze your tax situation, structure your investments efficiently, and align your portfolio with your financial goals.

By incorporating tax-aware investing into your strategy, you can improve your after-tax returns and keep your wealth growing over time.

Schedule a complimentary 30-minute discovery call with a fiduciary wealth advisor.