Investments & Tax Laws

Understanding how your investments are taxed is an important part of successful investing. Tax laws vary depending on the type of investment you own and how long you've owned it. Although tax laws can be complex, understanding the basics of investments and tax laws can help you save money and avoid penalties from the Internal Revenue Service.

Long-Term and Short-Term Capital Gains

When you sell stocks, bonds, mutual funds and similar types of investments, you realize a capital gain or loss. A capital gain occurs when you sell the asset for more than its original purchase price. You are taxed differently than other types of income on this revenue. No income tax is paid on a capital loss. Capital gains are classified as either short-term or long-term, and you pay a lower tax rate on long-term gains on investments held for one year or longer. If you hold an investment for less than one year, it's a short-term gain.

Capital Gains Rate

The capital gains tax applied to your investment depends on your marginal tax bracket. As of the date of publication, individuals in the 10 or 15 percent tax bracket are taxed at zero percent for gains on long-term investments, while individuals in higher tax brackets are taxed at a 15 percent capital gains tax rate. According to Ameriprise Financial, these tax rates do not apply to all investments. For example, a long-term capital gain realized on the sale of an antique is taxed at a maximum of 28 percent.

Ordinary Income

Rental income, dividends from bonds and mutual funds and interest earned on certificates of deposit and annuities are taxed as ordinary income. In contrast to capital gains, income from these sources is taxed at ordinary income rates. You must report ordinary income on your federal tax return. Some types of investment income is tax deferred. You are not required to pay ordinary income tax until you withdraw money from the investment. For example, money in a 401k retirement account is considered tax deferred.

Tax-Free Investments

U.S. government-issued securities and municipal bonds qualify as tax exempt, meaning you do not pay federal taxes on the income you receive. Federal, state and local governments issue securities to raise funds for special projects. Some mutual funds also offer tax-free features. Tax-free investments are advantageous for high-income earners. Although tax-exempt investments save you money, they also offer much lower returns than taxable investments.

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