To make the most of your investment, it’s essential to understand how investments are taxed. It’s to your advantage to build a diversified portfolio that is held in a combination of tax-free, tax-advantaged, and taxable investment accounts. Through the strategic selection and location of investments amongst these types of account, it may be possible to reduce the taxes you pay overtime and achieve a higher after-tax return.

You may be putting money into a variety of investments: real estate, stocks and bonds, mutual funds, exchange-traded funds (ETFs), and more. The return—or profit—from various investments are taxed differently, and the investments you choose can affect your overall tax liability. As a result, tax implications should be a major criteria in both choosing investments and investment accounts.

Types of Taxes That Affect Investment Returns:

Capital Gains Taxes

When you invest in stocks, real estate investment trusts (REITs), mutual funds, bonds and ETFs outside of a retirement account, the capital gains tax comes into the picture. For stocks, when you sell shares, you are taxed on capital gains at a rate that is based on how long you held the stock.

• For stocks held less than one year, you will owe tax at the short-term capital gains rate, which is usually the same as your ordinary income tax rate.
• For stocks held longer than one year, you’ll be taxed at the long-term capital gains rate, which is based on your tax bracket and typically assessed at lower rates than your ordinary income. As of 2025, the top long-term capital gains rate is 20%.

Taxes on Dividends

When you earn dividends on stocks, the funds are taxed at a rate based on the type of dividend: non-qualified or qualified. The difference is determined by how long you’ve held the shares, the country of origin, and the kind of distribution.

• Non-qualified dividends are taxed at your ordinary income tax rate.
• Qualified dividends are taxed at a potentially lower tax rate on the same schedule as long-term capital gains.

Taxes on Interest

When you earn interest, it is usually taxed at your ordinary income tax rate. This includes interest earned from savings accounts, certificates of deposit (CDs), loans made to others, and similar investments. Note that certain types of interest, such as municipal bond interest, may be exempt from federal income tax.

Tax-free Investment Accounts

Tax-free investment accounts are typically funded with after-tax dollars, so when you withdraw funds, including earnings, you may not be taxed.

• Roth 401(k) accounts: These are employer-sponsored retirement accounts that allow for after-tax contributions and withdrawals that are tax-free, if made as qualified distributions after age 59 ½. Roth 401(k)s have no income limit for participation, and their withdrawal and contribution limits are the same as regular 401(k) accounts (see below).
• Roth IRA: Here again, contributions are made with after-tax dollars, meaning later qualified withdrawals can be tax-free.
• 529 savings plans:These plans allow you to invest after-tax income into savings for qualified educational expenses, which include K-12 tuition and college expenses such as tuition, books, and room and board. Qualified withdrawals are tax-free.
• HSAs:Health savings accounts allow you to contribute pre-tax income and take it out tax-free to pay for qualified medical expenses. The yearly contribution limit for 2024 is $4,150 for individuals and $8,300 for families. However, you must be enrolled in a “high-deductible health plan” as defined by IRS guidelines in order to be eligible to contribute to an HSA.

Tax-advantaged Investment Accounts

• 401(k) investment accounts: 401(k)s are widely popular retirement savings plans sponsored by employers. Employees can choose to contribute pre-tax income with each paycheck, and employers often match a certain percentage of the contribution, which is often called “free money” for the employees. These plans are considered major perks in recruiting new staff.

  *For 2025, the annual contribution limit is $23,500 with an additional $7,500 if you are ages 50 to 59 or 64+. For participants who are 60 to 63, the catch-up limit is $11,250. Withdrawals made before you turn 59½ may incur an early-withdrawal penalty, a 10% tax. Withdrawals made after age 59½ are taxed as ordinary income. Minimum distributions are required after age 73 or 75, depending on your current age.

• 403(b) investment accounts: 403(b) accounts offer the same benefits as 401(k)s, but for employees of public schools and 501(c)(3) nonprofits. Similar rules apply, including annual contribution limits, early-withdrawal penalties, and mandatory withdrawals after age 73 or 75.
• Traditional IRAs: Individual retirement accounts offer similar benefits to the 401(k) for individuals, without employer involvement. The annual contribution for an IRA is $7,000 for 2025. An additional $1,000 per year can be invested by people over 50. As with 401(k)s, you will likely incur an additional 10 percent tax for early withdrawals, made before age 59½, and withdrawals must begin after age 73/75. In addition, withdrawals are taxed as regular income, based on your tax bracket.

Taxable Investment Accounts (Non-Retirement Accounts)

While these common accounts offer no tax advantages, they are more flexible, have no investment limits, and do not require keeping track of contribution and withdrawal limitations governing tax-advantaged accounts. Taxable investment accounts can hold stocks, bonds, mutual funds, ETFs, and more.

This category of tax classification also includes cash and savings accounts such as a standard checking or savings account, as well as money market deposit accounts, which generally offer a higher interest rate and are FDIC-insured for banks and NCUA-insured for credit unions, for up to $250,000.

Tax-Efficient Investing

Part of maintaining a tax-efficient portfolio is employing a combination of tax-advantaged, tax-free, and taxable investment accounts. Additionally, the makeup of your investment portfolio impacts your tax liability. Here are some basic ideas for tax-efficient investment:

• Planning is essential. Consider such factors as your current tax bracket versus the bracket you’ll be in when you retire, which may be lower for most individuals—one of the advantages of tax-advantaged retirement accounts. Since withdrawals from tax-deferred accounts produce additional ordinary income,
• distributions from these accounts may cause account holders to move up to higher tax brackets. Strategically taking distributions from accounts with different tax classifications, as well as timing distributions appropriately can help reduce the total tax liability from accessing income.
• Tax-loss harvesting. Investment losses can offset gains (profits) elsewhere and reduce your tax liability. This is a complex strategy, so it’s wise to consult with a financial professional.

These are the basics of how taxes and investments intertwine. Understanding these can help you plan investment and retirement strategies that can lower your lifetime tax bill and make the most of your investment opportunities. As always, the best advice is to consult with a financial professional who knows the rules and your personal situation.