In this article:
- What Are Taxable Accounts?
- How Are Investments Taxed?
- 5 Investments That May Result in a Larger Tax Bill
- Tips for Investing Without Big Tax Bills
Opening a taxable investment account opens the doors to a world of investment choices, from individual stocks to mutual funds, exchange-traded funds (ETFs) to bonds, trusts to cash accounts.
But all investment choices aren't taxed equally. And more, not all investment vehicles will be mindful of your growing tax liability. Some investments are more likely to result in larger gains, more taxable income and larger tax bills. If you're thinking of adding tax-unfriendly investments to your taxable portfolio, you may want to think twice.
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What Are Taxable Accounts?
Most bank accounts and brokerage accounts are taxable. Taxable accounts don't have special tax advantages that might defer or eliminate tax liability. In a taxable brokerage account, interest, dividends and capital gains are taxed by the federal government. By contrast, tax-advantaged accounts like individual retirement accounts (IRAs), health savings accounts (HSAs) and 529 education plans may defer taxes or allow tax-free earnings and withdrawals when you follow IRS guidelines.
How Are Investments Taxed?
When you invest using a taxable brokerage account, your taxable income may include:
- Capital gains: When you sell an investment for more than you paid for it, you'll pay income taxes on your capital gains. Short-term investments held for less than a year are taxed as regular income; long-term investments held for more than a year are taxed at more favorable capital gains rates: 0%, 15% or 20%.
- Dividends: Companies may periodically issue dividends to their shareholders as rewards or profit sharing. These dividends are taxable. Qualified dividends are taxed at long-term capital gains rates; ordinary dividends are taxed at short-term capital gains rates.
- Interest: Interest earned in savings accounts, certificates of deposit (CDs), money market accounts, corporate bonds and deposited insurance dividends are taxable as regular income.
When Are Taxes Especially High?
Paying some tax may be inevitable when you make money in a taxable account. Capital gains, dividends and interest are all taxable; they're also primary ways to make money on your investments. That said, some investing strategies may result in larger or more frequent gains, or particularly large amounts of taxable dividends and interest. Here are a few examples.
- Investments with high turnover: When stocks or fund holdings are sold frequently, they have a greater potential to generate capital gains.
- Short-term investments: Investments held for less than a year are taxed at a higher, short-term capital gains rate.
- Ordinary dividends and interest income: Both ordinary dividends and interest income are taxed as regular income.
- Dividend-focused investments: Investments that focus on paying lots of dividends can create lots of current taxable income.
5 Investments That May Result in a Larger Tax Bill
The following investments may generate high levels of taxable income, or income and gains that are taxed at higher rates.
1. Stocks You Hold for Less Than a Year
Selling stocks you've held for less than a year creates short-term capital gains. If your strategy is to do a lot of active stock trading, you may want to consider holding your stocks in a tax-advantaged account where you won't incur capital gains taxes.
2. Taxable Bonds and Bond Funds
Some bonds are not subject to federal income tax. Those that are subject to taxes generate interest income, which is taxable at your ordinary rate (see 2024 tax brackets for reference).
3. High-Turnover Funds
Actively managed funds periodically adjust their holdings, which can create a significant amount of capital gain. Actively managed equity funds and target date funds are two examples of fund types that are likely to move investments around to "rebalance"—and potentially create capital gains, including short-term gains.
4. Stocks and Funds That Pay Dividends
Dividends are not a bad thing, but they are considered taxable income in the year you receive them. If you're invested in stocks or funds that generate a lot of dividend income, your current-year tax bills may be high. By contrast, investments that are geared toward growth may increase in value without triggering capital gains, at least for as long as you hold them.
5. Real Estate Investment Trusts (REITs)
REITs are required to pay 90% of their taxable profits as dividends, often as highly taxed ordinary dividends. In this way, they're similar to dividend-paying funds and stocks: They create current-year taxable income.
Tips for Investing Without Big Tax Bills
To reduce your potential tax liability, think through your investment choices and consider whether opening one or more tax-advantaged accounts could save you some money. Here are a few tips to get you started.
Choose Tax-Friendly Investments
When you're selecting investments for your taxable account, look for choices that limit short-term capital gains, ordinary dividends, current income and interest. These might include the following:
- Stocks held for at least a year (and preferably longer) to avoid short-term capital gains
- Index and exchange-traded funds, which typically have low turnover
- Municipal bonds and Series I bonds, which are not taxed by the federal government
- Tax-managed funds that focus on keeping your tax liability low
Use Tax-Advantaged Accounts
Roth IRAs, HSAs and 529 college savings plans all allow you to invest your money without paying taxes on capital gains, dividends and interest as you go. These tax-advantaged accounts come with contribution limits and significant restrictions on qualification and use.
- Roth IRA contributions must meet income requirements. In 2024, contributions are limited to $7,000 ($8,000 if you're age 50 or older). A 10% early distribution penalty applies if you withdraw your Roth IRA earnings before you reach age 59½. If you meet qualifications, withdrawals are tax-free.
- HSAs are for people with qualifying high-deductible health plans. In 2024, you can contribute up to $4,150 for self-only coverage and $8,300 for family coverage, with an additional $1,000 contribution if you're age 55 or older. Withdrawals must be used to cover eligible health care expenses. If expenses qualify, your withdrawals are tax-free.
- 529 education plans offer tax savings when you invest for college, postgraduate education or private K-12 school. Although there are no federal contribution limits on 529 plans, your state may limit the amount you can contribute on behalf of any one child. You don't pay taxes on earnings while the account grows. Qualifying tax-free withdrawals may be used to pay for tuition, education costs and eligible living expenses.
Traditional IRAs and your 401(k) plan at work may also offer tax advantages. Although your withdrawals from these accounts are entirely taxable, capital gains, dividends and interest earned aren't taxable as long as the money is in your account.
The Bottom Line
Although managing your tax liability can help you get the most out of your investment returns, tax efficiency is only one factor to consider as you build and manage your investment portfolio. If you'd like some strategic help, consider working with a trusted investment advisor who can help you balance your money-making goals against tax savings, so you can make more—and keep more—as your portfolio grows.
