Each year, we field numerous client questions about minimizing their taxes. The questions tend to focus on how the tax advantages of a traditional IRA stack up to a Roth account and other basics. However, keeping our tax conversations high-level often means glossing over significant opportunities for tax savings. In this article, we’re going to dive in a bit deeper to look at how the IRS taxes different investments.

By understanding the basics, you’ll start to see how a holistic approach to tax and investing can create opportunities to save. Better yet, you’ll start to see that these opportunities aren’t just year-end optimizations or tools to improve your retirement—rather, they have year-round applications for any investor.

Investment income: Different tax rates apply

The standard tax treatment for investments (of any kind) is capital gains. Your capital gain is the difference between what you paid for an investment (the cost basis) and what you sold it for. We should note, this could also be a capital loss.

If you held the investment for less than a year, it qualifies as a short-term capital gain and is taxed as ordinary income. If you held the investment for more than a year, it qualifies for the lower long-term capital gains rate, which is 0%, 15%, or 20%, depending on your income level overall.

You can use capital losses to offset capital gains and lower your tax burden. These losses can be carried forward from one tax year to another. Good advisors try to be strategic about rebalancing client accounts or selling underperforming investments so they can harvest those losses for potential tax savings in the future. This approach is known as tax-loss harvesting.

Of course, capital gains aren’t the only way to make money investing. You can also earn interest or dividend payments.

Interest payments are taxed as ordinary income. So, if your high-yield savings account pays out 4% in annual interest on the $10,000 you hold there, that $400 counts toward your income for the year, and is subject to federal, state, and local taxes as applicable.

There are two notable exceptions to this rule.

1.  The interest paid on U.S. Treasuries (ranging from T-Bills to 10-year notes) is exempt from any state and local income taxes that might otherwise apply.

2. Interest paid on municipal (muni) bonds is generally tax exempt—at the federal, state, and local level.

When it comes to dividends, the IRS applies two categories: qualified and ordinary. The IRS taxes ordinary dividends like any other income but applies capital gains rates to qualified dividends.

For dividends to qualify, they must be paid by a U.S. corporation or a qualified (per the IRS) foreign company, and you must have owned the shares for at least 60 days prior to the ex-dividend date. In other words, if you’re buying shares right before they pay dividends because you want the income, those dividends may get taxed at a higher rate than if you were a long-term investor earning dividends on the same stock.

Why taxes matter: ETFs vs. mutual funds

The easiest way to highlight these tax rules in action may be to look at exchange-traded funds (ETFs) versus mutual funds.

When you invest in a mutual fund, your money goes directly toward buying the assets held by the fund. The mutual fund manager thinks through all of the tax considerations we’ve outlined when buying and selling investments within the fund (tax strategy should be covered in the fund prospectus). Ultimately, however, you are responsible for the taxable events that occur because you own the holdings within the fund. While you won’t (usually) owe the IRS money if you didn’t cash out of the fund, you’ll see these taxable events reflected in your Form-1099 DIV each year.

With ETFs, on the other hand, you aren’t investing directly in the funds’ holdings. Rather, the fund owns or tracks the underlying assets, and you own a share of the fund. As such, you aren’t responsible for the taxable events that might occur within the fund throughout the year. Instead, you’ll record capital gains (or losses) only when you sell your shares of the ETF itself; you’ll record dividend income only if the ETF itself pays a dividend.

Most index funds are structured as either mutual funds or ETFs, so it’s important to understand the differences in how they’re taxed. (You may hear these products referred to as investment vehicles, since most investors actually want exposure to the underlying assets, and these products simply carry those investments—like a vehicle.)

Tax-advantaged accounts

Most of us hold shares of mutual funds or ETFs in some type of investment account—a brokerage account managed by your financial advisor, for instance, or your work 401(k).

With taxable accounts, your investments are subject to the rules we’ve discussed.

With tax-advantaged accounts, however, there’s more to consider.

With traditional retirement accounts (like a 401(k) or IRA), you contribute money tax-free, it grows tax-free, and then you pay ordinary income taxes on those withdrawals in retirement. (These tax advantages come with certain rules.) With a Roth IRA, you pay income tax on the money you contribute to the account, then the investments grow tax-free, and you can take tax-free withdrawals in retirement.

Now consider the tax rules we’ve discussed to this point: You might start to see some opportunities for planning. For instance, why would you hold municipal bonds in a traditional IRA when the interest payments are tax-exempt? There’s no tax benefit involved. Putting them in a different account would create a better tax location for those bonds. 

If we dig deeper, we discover more opportunities. Consider this hypothetical example concerning concentrated stock positions:

Your employer pays you a bonus of company stock at $10 a share. You’re thrilled because they pay it directly into your 401(k), meaning you skip the income tax generally associated with a bonus. Now fast forward 20 years—those shares increased in values from $10 to $110 ($100 profit per share). You’re ready to cash out and retire.

Because you held those shares in your 401(k), selling them wouldn’t trigger a taxable event (investments grow tax-free), but when you withdraw the money, you’d pay income tax on your profits. Remember: Income tax is usually higher than capital gains tax. So, in this scenario, using a tax-advantaged retirement account could increase your tax bill.

An advisor can help you avoid this type of scenario. However, if you made this misstep 20 years ago, an advisor could also help you right the situation today using a strategy called net unrealized appreciation (NUA), which essentially recategorizes those shares as if they were paid to a brokerage account, effectively lowering your tax bill.

These techniques are complicated and don’t get as much coverage in financial media, as they require you to understand a fair amount of tax law. A financial advisor can help you spot these types of savings and avoid mistakes without you having to learn any additional information about IRS classifications.

How Revo Financial can help

Our team is consistently on the lookout for opportunities to help you reduce what you owe the IRS. Whether through more active techniques like tax-loss harvesting or by ensuring  you don’t have tax-advantaged assets (like muni bonds) in a tax-advantaged account, these adjustments can make a significant difference over time.

Additionally, this type of holistic approach to tax and investing creates opportunities all year, not just at the end of December or leading up to April 15. If you’re ready to take a more proactive approach to what you pay the IRS, set up an appointment with our team.