There are four main taxes that are applied to investment returns in the U.S.: Long-term capital gains tax, federal income tax, state income tax, and taxes withheld by foreign governments. In addition, high earners also need to take the net investment income tax (NIIT) into consideration.
Long-term capital gains tax
Long-term capital gains are profits you make from selling assets (e.g., stocks, bonds, real estate, and collectibles) held for more than one year (with a few exceptions on some real estate transactions). Long-term capital gains are subject to a lower tax rate compared to the ordinary income tax rate.
In addition, qualified dividends that meet certain holding period requirements are subject to the same lower long-term capital gains tax rate. For dividends to be considered qualified, you must hold the stock for more than 61 days during the 121-day period that begins 60 days before the ex-dividend date.
The long-term capital gains tax rate is 0 percent, 15 percent, and 20 percent, depending on your taxable income. The following table lists the taxable income ranges and the corresponding tax rate for 2023 (source: IRS).
| Tax rate | Single | Married filing jointly or qualifying widow(er) | Head of household | Married filing separately |
|---|---|---|---|---|
| 0% | $0 to $41,675 | $0 to $83,350 | $0 to $55,800 | $0 to $41,675 |
| 15% | $41,676 to $459,750 | $83,351 to $517,200 | $55,801 to $488,500 | $41,676 to $258,600 |
| 20% | $459,751 or more | $517,201 or more | $488,501 or more | $258,601 or more |
Based on the income ranges shown in the previous table, most investors will fall into the 0 and 15 percent buckets.
There are a few exceptions when selling small business stocks, collectibles, and real estate, which are described on the IRS website. However, most investors usually only need to deal with the tax rates listed above.
Since the long-term capital gains tax rates are substantially lower than the respective federal income tax rates on an income by income basis, the government is effectively encouraging investors to invest for the long term.
Short-term gains and federal income tax
Profits from selling assets and dividends from stocks that you held for one year or less are taxed as short-term capital gains and are treated as ordinary income from a taxation perspective and thus are taxed using the regular federal income tax rates. In addition, interest income from savings accounts, money market accounts, and bonds are taxed as ordinary income as well. However, there is one exception: interest income from municipal bonds are usually exempt from the federal income tax and from state taxes for residents of the issuing state.
The following table lists the federal income tax brackets for 2023 (source: IRS).
| Tax rate | Single | Married filing jointly or qualifying widow(er) | Head of household | Married filing separately |
|---|---|---|---|---|
| 10% | $0 to $11,000 | $0 to $22,000 | $0 to $15,700 | $0 to $11,000 |
| 12% | $11,001 to $44,725 | $22,001 to $89,450 | $15,701 to $59,850 | $11,001 to $44,725 |
| 22% | $44,726 to $95,375 | $89,451 to $190,750 | $59,851 to $95,350 | $44,726 to $95,375 |
| 24% | $95,376 to $182,100 | $190,751 to $364,200 | $95,351 to $182,100 | $95,376 to $182,100 |
| 32% | $182,101 to $231,250 | $364,201 to $462,500 | $182,101 to $231,250 | $182,101 to $231,250 |
| 35% | $231,251 to $578,125 | $462,501 to $693,750 | $231,251 to $578,100 | $231,251 to $346,875 |
| 37% | $578,126 or more | $693,751 or more | $578,101 or more | $346,876 or more |
State income tax
Some states impose an income tax on investment income (profits, dividends, and interest income). The tax rate depends on the state that you live in. There is one major exception when it comes to state income taxes: interest income from treasury securities are only subject to federal income tax and are exempt from state taxes.
Taxes withheld by foreign governments
When you buy foreign securities (mainly stocks and bonds), some foreign governments withhold taxes on the income of some securities. Because the income of those securities are also subject to taxes in the U.S., you effectively pay double taxes on some foreign securities. There are ways to prevent double taxation by receiving a foreign tax credit from the U.S. government, but this only works if you bought the foreign securities in a taxable account (otherwise there is nothing you can apply the foreign tax credit to).
The following table summarizes the taxes on investment returns in the U.S.
| Asset type | Long-term capital gains tax | Federal income tax | State income tax | Foreign government tax |
|---|---|---|---|---|
| Capital gains, qualified dividends | Applies if assets are held for at least one year | Applies if assets are held for less than one year | Imposed in some states | On foreign securities |
| Interest income from savings accounts, money market accounts, corporate bonds, non-treasury government securities | N/A | Subject to federal income tax | Imposed in some states | On foreign securities |
| Interest income from treasury securities | N/A | Subject to federal income tax | Exempt from state taxes | N/A |
| Interest income from municipal bonds | N/A | Exempt from federal income tax | Exempt from state taxes for residents of the issuing state | N/A |
Net investment income tax
In addition to the previous taxes, high earners are liable for a 3.8 percent net investment income tax (NIIT) if their modified adjusted gross income (MAGI) exceeds the statutory threshold. The MAGI thresholds are listed in the following table (source: IRS).
| Filing status | MAGI threshold |
|---|---|
| Single or head of household | $200,000 |
| Married filing jointly or qualifying widow(er) | $250,000 |
| Married filing separately | $125,000 |
Net investment income includes capital gains, dividends, interest, rental and royalty income, non-qualified annuities, but generally does not apply to wages and self-employment income, social security benefits, unemployment compensation, and alimony.
If your MAGI is greater than the threshold, the lesser of your net investment income or the portion that exceeds the threshold is subject to a 3.8 percent net investment income tax.
Here are two examples to illustrate the calculation:
- You are a single filer and your MAGI is $210,000 and your net investment income is $20,000. Your MAGI exceeds the threshold by $10,000, which is less than your net investment income. In this case you are liable for 3.8 percent on $10,000, which is $380.
- You are a married filer filing jointly and your MAGI is $290,000 and your net investment income is $30,000. Your MAGI exceeds the threshold by $40,000, which is more than your net investment income. In this case you are liable for 3.8 percent on $30,000, which is $1,140.