Investment Taxes 101
My friends, I have good news and I have bad news.
The good news is that investment taxes are a lot simpler and easier than you may expect. The bad news is that you’re about to hate your earned income by comparison.
Welcome to your crash course on everything from capital gains and dividends to tax loss harvesting and rebalancing—feel free to Ctrl+F if you’re here to answer a specific question. But if not, welcome to the chocolate factory—I’ll be your Wonka.
Taxes on brokerage accounts
Capital gains taxes
Dividends
Rebalancing
Tax loss harvesting
What to expect at tax time
So let’s start with the best part:
Unless you’re retired and drawing down on your retirement accounts, you don’t have to worry about your 401(k)s and IRAs during tax season.
Your 401(k) and IRA are great tax-advantaged investment vehicles. You aren’t taxed on the growth in those accounts every year the same way you’re taxed on the growth in your taxable accounts. After all, that’s kinda the point.
So what does this mean? You can buy and sell and rack up dividends and interest inside these accounts without worrying about paying taxes annually on any of the gains. It’s all tax-sheltered.
The TL;DR: If you do all of your investing inside retirement accounts, nothing I’m about to share really applies to your situation. We really only need to concern ourselves with investment taxes during our accumulation phase inside taxable brokerage accounts.
(And a note: The term “taxable” gets its name from the fact that it refers to pretty much everything that isn’t a tax-advantaged retirement account.)
So if you have brokerage accounts, what do you need to know about the taxes?
If you contributed to a brokerage account over the last 12 months, it’s likely that you experienced some gain or loss. For example, if you invested $1,000 in March 2023 and today you have $1,200, that $200 difference is your capital gain. It’s the gain that your capital of $1,000 earned.
For most index fund investors, growth will be composed of two things:
Capital gains, where the asset went up in value; in other words, it’s worth more now than when you bought it
Dividends, which you can think about like a token of appreciation from a company; the company is essentially distributing its profits to shareholders directly, and some companies offer higher “dividend yields” than others
For example, if you buy a $20 share of a company that offers a dividend yield of 5%, you’d earn $1/share.
Capital gains and dividends are taxed differently than earned income—and if you’re just dollar-cost averaging into an account and not selling anything, you won’t pay any taxes on the capital gains.
You only pay taxes on capital gains when you “realize” them, which essentially means when you sell at a gain for any reason. You may be wondering: If I’m selling something within my brokerage account but then using the money to buy something else and not withdrawing anything, do I still have to pay taxes on the gains? The answer is yes.
Even if all the money stays within the confines of the brokerage account, those “realized gains and losses” from buying and selling still trigger a tax event.
So let’s talk about how capital gains are taxed, when you finally sell.
Your capital gains are taxed based on how long you held and your total income from all sources—your salary, your side hustle, your investment income—add it all together and imagine stacking the capital gains on the very tippy top.
If you sell after…
Fewer than 365 days: You’ll pay your marginal tax rate on the gain. This is definitely suboptimal and should be avoided if possible.
For example, if we had sold our $20 share at $25 after, say, six months, and we’re in the 24% tax bracket, we’d pay $1.20 in taxes on the gain of $5. Gross. Of course, it’s still better than nothing—you still have $3.80 you didn’t have before—but you’re less ahead than you could have been if you had waited or sold older shares first.
Greater than 365 days: You’ll pay the capital gains tax rate on the gains. The capital gains and qualified dividends tax brackets are a lot easier to navigate than the progressive tax system and can be way more forgiving.
If you (as a single person in 2024) have $47,025 or less in total declared income, you won’t pay any taxes on your long-term capital gains. For married filing jointly, the 0% bracket covers up to $94,050 in total income.
If you have between $47,026 and $518,900 in income in 2024 (yep, that’s not a typo), you’ll pay 15%. For married filing jointly, it’s $94,051 to $583,750.
And if you have $518,901+ in income, you’ll pay 20%. If you’re married, it’s a total income above $5551,351.
Because of how broad it is, most people fall into the 15% category.
So remember our $1.20 in taxes on our $5 short-term capital gain before? If they were long-term capital gains, we’d pay 75 cents. And even if you’re bringing in $400,000 per year as a single person and would be in the 35% marginal tax bracket, your investment income (the capital gains) are only taxed at 15%.
But what if you’ve been dollar-cost averaging into various holdings over time? If you’ve been adding little by little, how does the brokerage firm know what to sell? The shares I bought last week, or the shares I bought three years ago? My gain will be different depending on my cost basis (the amount I paid for it), so how do I know?
Brokerage firms typically use FIFO—first in, first out—automatically, though it’s definitely worth a Google for your brokerage firm. This means they’ll sell your oldest shares first to satisfy a sell order. If you bought something three years ago that has a $5 gain and more of it last year that has a $2 gain, it’ll sell the older shares with a lower cost basis first.
Firms like Betterment make this pretty easy, too; they’ll warn you of the tax impact of selling before you press any scary buttons, and confirm you still want to make the move.
And don’t forget about state capital gains taxes, which vary depending on where you live and how much you earn. Here’s a list from SmartAsset; Command-F to your heart’s content to find your state’s rates (now I know why everyone retires to Florida).
But let’s circle back to those dividends, because they’re taxed a little bit differently
Your dividends will be taxed annually whether you reinvest them or not (that is, whether you keep them in the account and set them to “reinvest,” or withdraw them). You pay taxes regardless, because they’re always considered “income” in the year you earn them.
There are two types of dividends:
Ordinary dividends are taxed like ordinary income; in other words, you’ll pay your regular tax rate on these bad boys.
Qualified dividends that meet certain requirements are taxed similarly to capital gains using the more forgiving brackets described before.
Your 1099-DIV that you receive from the brokerage firm will clearly outline both your qualified and ordinary dividend amounts.
Now, it’s important to note: If you’ve set your dividends to reinvest (which is generally the advisable thing to do), you’re technically being taxed on income that you never withdrew as cash—which is different from the way you’re taxed on the income you receive on your paycheck, because you’ll essentially need money from another source to pay a tax bill associated with your dividends. This won’t be much in the beginning, but if you have a huge brokerage account worth hundreds of thousands or millions of dollars, you could theoretically generate a dividend income tax bill in the thousands.
You may not need to sell any holdings because you need cash, but you may find yourself in a position where you need to sell in order to rebalance your portfolio.
Rebalancing is effectively saying, “Okay, my goal was to own 90% stocks and 10% bonds across my portfolio, but 5 years have passed, and my stocks grew way faster than my bonds did, so now, my actual allocation is 95% stocks and 5% bonds,” which might be too risky for your liking.
In order to get back to your goal allocation of 90/10, you have two options:
You can sell stocks and use the money to buy bonds.
Or, if you’re still contributing and growing your accounts, you can contribute your new cash in such a way that it buys more bonds than stocks for a little while until your bond allocation is larger.
Keep in mind, though: It’s helpful to think about your portfolio holistically, as the sum of its individual parts, because it’s a lot easier to buy and sell within tax-advantaged accounts—so it’s possible you could handle the majority of your rebalancing within those accounts, depending on how much you’ve squirreled away across them.
In a scenario where your money is primarily allocated to tax-advantaged accounts, you may decide to venture over to a 401(k) that’s beefy and offload some of your longest-held stocks to reinvest in bonds and leave the brokerage account alone.
If you find yourself rebalancing, you have a few considerations:
The first is to try to rebalance within tax-advantaged accounts where you won’t get dinged with capital gains taxes.
The second is to be mindful of the upper capital gains tax bracket where you’d creep into 20% territory. If you’re a high earner and/or selling a lot at once to rebalance, you want to ensure you don’t accidentally breach the upper limit of the 15% bracket and begin paying 20% on some of your gains.
Ideally, this is something that can be done little by little over time, rather than all at once.
So far, we’ve mostly talked about how taxes affect your investments if your holdings are up—but what if your stocks are down?
If you invested money that’s at a loss (for example, how most of our portfolios looked at the end of 2022!), tax loss harvesting is effectively what happens when you say, “Hey, I invested $100 and now I only have $80. I want to take a tax deduction on the $20 I lost to help ease the pain of failure.” Just kidding. You’re not a failure. You’re an investor along for the ride!
Here’s how it works: You sell a holding that’s decreased in value so you can recognize a capital loss (your 1099-DIV should also list your capital losses), which can then be used to offset gains from other investments.
The important part, however, is not that you’re just cashing out and walking out of the stock market casino. You’re reinvesting your $80 in something similar, but not “substantially identical.” You could sell a position in the S&P 500, lock in your loss for the year, then immediately turn around and invest that same cash into a Total Stock Market fund, which has such similar holdings that it’s effectively giving you exposure to almost the same thing—cap-weighted US stocks—but you’re also benefiting from the loss you experienced.
“There’s no such thing as tax loss harvesting in an account where you aren’t subjected to capital gains taxes, like a 401(k).”
Unfortunately, you have to sell by the last day of the year, so it’s too late to do this for 2023 securities—but keep it in your back pocket in the future. If you use a robo adviser like Betterment, this happens automatically if you have the feature turned on.
This is only a benefit in taxable accounts—there’s no such thing as tax loss harvesting in an account where you aren’t subjected to capital gains taxes, like a 401(k).
This is a bit of a tricky maneuver: For one thing, you want to be careful of avoiding what’s known as a wash sale.
This is when you sell an investment at a loss, but buy a “substantially identical stock” within 30 days before or after that sale. Note that the wash sale rule also applies to any substantially identical stocks or securities purchased by your spouse or a company you own, so if you were thinking of getting crafty by assigning bae some Robinhood homework, think again.
This can be complicated if you have a lot of multiple accounts that are dollar-cost averaging into similar holdings. To extend our earlier example, if I sold my S&P 500 holdings at a loss to repurchase the Total Stock Market in my brokerage account, but my 401(k) plan purchased the S&P 500 two weeks later as part of its standard operating procedure, I’m pretty sure this would trigger a wash sale and invalidate the whole thing.
Regardless, when executed correctly, you can typically deduct up to $3,000 of losses per year, and if you have losses in excess of $3,000, you can carry them forward into the future to offset Future You’s gains.
Phew, okay. So, should all this talk about taxes scare you away from investing?
Well, would you turn down a raise because it means you’re going to have to pay taxes on that incremental money? No, probably not.
But this post makes a decent support case for maximizing your 401(k) and IRA contributions first, since the ongoing tax situation on those bad boys is pretty simple.
For everything else, there are ways to help minimize the pain. First and foremost: Try your best not to sell assets that you’ve had for less than a year. That’s one great way to help minimize your tax liability on growth, since once you cross the one-year mark, you’ll be dropped down into those sweet, sweet capital gains tax brackets.
What can you expect at tax time?
Most firms will send you something called a 1099-DIV (or maybe a 1099 Composite) by mid-February. This will list your capital gains, ordinary dividends, qualified dividends, etc., and you’ll upload the form to your tax software of choice or give to your CPA.
Even if this feels like a lot to manage yourself, you have options:
If you invest with a roboadvisor, it’s likely they’ll have automatic rebalancing and tax loss harvesting features you can turn on so you don’t have to worry about doing it manually.
Plus, your 1099-DIV forms will spell out the results of each account for you, so get familiar with them! It’s relatively easy to plug the numbers into tax software, but there’s no shame in hiring a CPA to handle it for you—they can answer questions and make suggestions that may lessen your tax burden.
And remember the best news of all. If you're making enough income from your investments to be taxed on it, you're in #RichGirl territory. Embrace it.
