Besides knowing how investment earnings are paid out, it is important to know how your earnings will be taxed.
How interest is taxed
Interest on bonds, certificates, and savings accounts is taxed as ordinary income unless the investment is tax exempt or deferred— as it is with many retirement accounts and municipal bonds.
Interest of most municipal bonds issued by states and their subdivisions is generally free of federal income tax and also generally free of those states' income taxes, if any.
That said, income from tax-exempt municipal bonds or municipal bond funds may be subject to other state and local taxes, and for certain bonds may be subject to the federal alternative minimum tax for certain investors. Federal income tax rules will also apply to any capital gains. US government bonds are free of state taxes.
How dividends are taxed
Ordinary dividends are taxed at the taxpayer's ordinary income tax bracket.
Certain qualified dividends, however, are taxed at the lower capital gains rates: 0%, 15%, and 20%, depending on the amount of taxable income.
How short-term capital gains are treated
Short-term capital gains, which are gains on investments that are held for a year or less, are taxed at your ordinary income tax rate.
How long-term capital gains are treated
Capital gains on investments that are held for more than a year (called long-term capital gains) are taxed at a lower rate than most other forms of income.
Prior to the new tax law that took effect in 2018, net long-term capital gains were taxed at 20% for taxpayers in the 39.6% tax bracket, and 15% for taxpayers in the 25% to 35% brackets. For those in the 10% and 15% brackets, long-term capital gains were taxed at 0%.
The new law establishes income levels rather than tax brackets for both long-term capital gains and qualified dividends. These income levels also differ according to filing status; the chart below shows the levels for a single person.
Net investment income tax
A 3.8% net investment income tax applies to certain net investment income of high-income individuals, estates, and certain trusts. For individuals, the tax generally applies to taxpayers who have certain investment income (such as interest, dividends, capital gains, etc.) and also have more than $200,000 of modified adjusted gross income if single taxpayers, or $250,000 if married taxpayers filing jointly
You can deduct net capital losses
Another important tax implication is centered on capital losses—the opposite of capital gains. If you lose money on your investments, you may be able to deduct up to $3,000 of your losses in excess of any capital gains from your taxable ordinary income. Losses over $3,000 may be carried over to future years.
This explains why so many people sell their stocks in December. Investors often choose to unload securities that are losing money in December in order to offset capital gains realized elsewhere in their portfolio and incidentally take advantage of this deduction on their income tax forms.
Dive deeper: Types of taxes: Understanding what you pay and why
This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.
Read more information and tips in our Taxes section