Investment Taxes 101: Capital Gains, Dividends, Tax Loss Harvesting, & More

Katie: Today we are talking about the world's sexiest topic, and I know what you're thinking. You're thinking, oh, the Ariana Grande music video for ”Side to Side.” No, investment taxes. Welcome back to The Money with Katie Show, Rich Girls and Boys. I'm your host, Katie Gatti Tassin. And to begin today, gather 'round for a story. 'Twas the tax season of 2019 for 2018 taxes, and yours truly was an investing spring chicken. I had put a few thousand dollars in different accounts, and I felt positively hashtag #adult about it. I was talking on the phone with my dad while strolling the aisles of Kroger for that week's rations of potato chips and Oreos, explaining how I was so ahead of the game that I had already filed my tax return. “But have you gotten your 1099s yet?” he asked me. “What?” I scoffed that my dad clearly knew nothing of the financial wizard I was. And he was like, “No, your 1099s, like from your investment accounts.” And panic ensued. “I have to pay taxes on those?” I asked, completely incredulous. “Why didn't anyone tell me?”

And that's how I found out that you have to pay taxes on your investment accounts. Surprise! Guys, it has been an absolute glow-up over the last five years. Started from the bottom, now the whole team here. Luckily I had so little that it wasn't too harsh of a course correction, but the more you sock away in your investment accounts, the more crucial it becomes that you stay on top of reporting it. 

So with that, 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, but the bad news is that you are about to hate your earned income by comparison. We'll be right back after a message from the sponsors of today's episode. 

Sponsored content: Okay, friends, it is that time again. Yep, I am talking about tax season. And you can take the stress out of filing by using TaxAct. Getting started is easy, thanks to TaxAct’s step-by-step guidance. And if you used a different provider last year, you can upload a PDF of your return to easily switch. Whether you're new to TaxAct or a previous filer, they will help you get the most out of your taxes, like your maximum refund guaranteed. And you can rest easy knowing the math adds up. If they make a mistake, TaxAct’s $100,000 accuracy guarantee will pay out up to $100,000 to cover the error. That is the strongest accuracy guarantee in the industry. Get your return started at taxact.com/moneywithkatie. That's taxact.com/moneywithkatie. 

Katie: All right, let's get the really good news out of the way first, shall we? Unless you're retired and drawing down on these accounts, you don't have to worry about your 401(k)s and IRAs during tax season. So if you are solely a qualified retirement account investor, you can breathe easy knowing your tax obligations are a long way off. While your traditional 401(k) and IRA are great tax deduction vehicles, and you should definitely fill out that portion of the tax software if it's not automatically done for you so you get the benefit of your deduction, you aren't taxed on the growth in those accounts the same way you're taxed on the growth in your taxable accounts. After all, that's kind of the point, that you can set it and forget it. Same with your Roth accounts, because you paid the taxes on the income up front, then invested it. You won't have to pay taxes on those gains in retirement.

So what does this mean? You can rebalance inside these accounts. Translation: You can buy and sell shit to your heart's content without worrying about capital gains or losses. It's all tax-sheltered, which is just a fancy way of saying the IRS is not really concerned about gains or losses under your Traditional or Roth umbrellas. So if you're going to try your hand at high-frequency day trading, your Roth IRA might actually be a great place to do it. That is a joke. Please don't day trade. 

But depending on how much of your net worth you have socked away in tax-sheltered places like 401(k)s and IRAs, you could theoretically do the majority of your rebalancing inside them and avoid messing with your taxable accounts at all. So we'll come back to rebalancing shortly. 

But on the taxable account front, the term “taxable investing” gets its name from the fact that it refers to pretty much everything that isn't a tax-advantaged retirement account. So I'd venture a guess that roughly 90% of the time when you're talking about investing colloquially, you're talking about a taxable brokerage account. So how do your taxes work inside a regular old not-for-retirement brokerage account? 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 a thousand dollars in March 2022 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, your gains will be composed of two things: capital gains, aka yes, it went up in value—it's worth more now than when you bought it, and dividends. So think about dividends like a token of appreciation from a company, like the company is essentially just distributing its profits to its shareholders, 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 would earn $1 per share. Capital gains and dividends are taxed differently than earned income. And if you set it and forget it and do nothing, say you just choose the setting that reinvests any dividends you get, you won't pay any taxes on the capital gains portion of the equation. But your dividends are another story. 

So I used to get really confused about this process. I was like, okay, well, if I sell something in the account just to buy something else, but I keep the money in the account, does that still trigger a tax event? And the answer is yes. Unless you're buying and selling in a tax-sheltered account like the retirement options we outlined earlier, 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 you may be selling because you have a life event that requires you to access the money, as in, you're cashing out completely, you're taking your chips off the table. You also may find yourself selling because you're just trying to do some portfolio rebalancing and you'd like to close or shrink a position in one thing to open or grow a position in something else. You pay taxes on capital gains when you realize them, which essentially means when you sell at a gain for any reason. So using the example above, if you sold your share that you bought for $20 at $25, your profits of $5 are fair game for the IRS to wrap its grubby little paws around and take a cut. Now, if you sell at a loss—say you bought for $20 and sold at $15—you can claim that as a deduction, and you may be able to use the loss to offset other capital gains. We'll circle back to that in a little bit. 

But what if you've been dollar cost averaging into various holdings over time? This is fairly straightforward if you bought a bunch of something all at once and then you sold it later. But 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 obviously be different depending on my cost basis, which is the amount that I paid for it. So how do I know? Brokerage firms typically use” first in, first out,” often abbreviated FIFO, automatically, though it's definitely worth a Google for your brokerage firm. So when I googled “Vanguard automatically sells FIFO,” it popped right up. 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 you bought more of it last year and that has a $2 gain, it'll sell the older shares with a lower cost basis and higher capital gains first. Firms like Betterment make this pretty easy, too. They'll warn you of the tax impact of selling before you press any of the scary buttons and confirm that you still wanna make the move. 

So why does this matter? It matters because when you purchased tells the IRS if it should treat your gains as long-term or short-term, and the long-term rates are far more favorable.

So let's talk about how capital gains are taxed when you do finally sell, because you're going to sell eventually, whether that's in the short term to pay for a medical emergency, hashtag #UShealthcarehellscape, or in the long term, 15 years from now when you're kissing corporate America goodbye and you're signing up for tango lessons. So there are two ways that capital gains may be taxed, depending on how long you held the security, based on your total declared income. Now by total declared income, I mean your income from all sources. So think your salary, your side hustle, your investment income. Add it all together, imagine stacking it all up, and then putting the capital gains at the very tippy top. 

So most people fall into the 15% capital gains tax bracket. But for the sake of edification, here is the breakdown. If you sell in less than 365 days, so one year, you'll pay your marginal tax rate on the gain. This is definitely suboptimal and should be avoided, if possible. So 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 our gain of $5. Gross. Of course, it's still better than nothing. You still have $3.90 you didn't have before, but you are less ahead than you could have been if you had just waited or sold your older shares first.

So if you sell after 365 days (one year), you'll pay the capital gains tax rate on the gains. Everyone is pretty familiar, I think, with the regular tax brackets, and most of us usually fall in that 22% to 24% range of our progressive tax system. But the capital gains and qualified dividends tax brackets are a lot easier to navigate and can be way more forgiving. And that is the good news about investing. 

So if you as a single person in 2022 have $41,675 or less in total declared income, you won't pay any taxes on your long-term capital gains. That's right: 0%. So for married filing jointly, the 0% bracket is up to $83,350 in total income in 2022. If you have between $41,676 and $459,750 in income—yes, that is not a mistake, $459k—you'll pay 15%, and for married filing jointly it's $83,351 up to $517,200. Then if you're single and you have more than $459,751, or you're married and it's above $517,200 in income, you'll pay 20% on the gains.

So because of how broad it is, like I said, most people are gonna fall into that 15% category. So remember in our earlier example of our $1.20 in taxes on our $5 short-term capital gain before? If those were long-term capital gains, we'd only be paying 75 cents, and that's it. So yeah, a little less convoluted than earned income taxation, right? Even if you're bringing in $400,000 per year as a single person and would be taxed in the 35% marginal tax bracket, your investment income, your capital gains, assuming they are long term, are only taxed at 15%.

But let's circle back to dividends, because as I mentioned, they are taxed a little bit differently. If you're cruising with your investment accounts and you're in it for the long term, you may be like, “Cool, I'm good. I'm not selling. I don't plan to sell for many years. I won't have any tax liability until I do, so I don't have to worry about any of this.” Not so fast, speed racer. 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 you are withdrawing them and using them as cash, you are gonna pay taxes regardless. 

So there are two types of dividends. Ordinary dividends are taxed like ordinary income. So in other words, you will pay your marginal regular tax rate on these bad boys. Qualified dividends that meet certain requirements are taxed similarly to capital gains at those lower rates that we just discussed, using the more forgiving brackets. Your 1099-DIV form that you received from the brokerage firm (so, you know, the form that I didn't wait for in 2019) will clearly outline both your qualified and ordinary dividend amounts. And at the end of this episode, I'll bring it all home with a little example. We'll be right back after a message from the sponsors of today's episode.

Sponsored content: We've recently partnered with TaxAct to create a custom episode of The Money with Katie Show, all about changes you should be aware of in tax season 2023. The full episode is up on our YouTube page, but we're also going to be playing excerpts during our other episodes for the next few weeks in lieu of traditional advertisements. Here's a little bit of my conversation with TaxAct’s VP of tax operations, Mark Jaeger. 

Katie: If we're talking about taxing something relatively small like Venmo payments, I've seen a lot of chatter about the Venmo payments. How does the IRS even track you down? Like, am I gonna get audited if my friend jokingly sends me a Venmo payment about having done professional work for them?

Mark Jaeger: Yeah, absolutely not. No, no, they don't have that kind of information to access third-party systems outside the government. They moved forward with these form 1099-K changes, or at least the politicians did as part of the American Rescue Plan Act, though the IRS ended up pulling it away. So there's nothing they can do, or no, as it relates to things happening in your bank accounts, things happening through Venmo, unless Venmo or a bank would actually share that information with them. 

Katie: I hope you enjoyed that excerpt from our conversation. Now back to our regularly scheduled programming, and as always, happy tax season.

So what about rebalancing? Because as I noted earlier, it's likely that you have money in a few different places. You probably have multiple qualified accounts like 401(k)s and Roth IRAs and rollover IRAs, and you may have brokerage accounts, too. So when you think about rebalancing, a definition that we will unpack, it's helpful to think about your portfolio holistically as the sum of its individual parts. So we already mentioned that it is a lot easier to buy and sell within tax advantaged accounts. So it's possible that you could handle the majority of your rebalancing within those accounts, depending on how much you've squirreled away across them, because rebalancing is effectively you saying, “Okay, my goal was to own 90% stocks and 10% bonds, but five years have passed and my stocks grew way faster than my bonds did. So now my actual allocation is 95% stocks and 5% bonds.” So that's a simple breakdown. You may own more than just stocks and bonds, but we're keeping it simple. So you may have determined that that 90/10 split was the risk level that you were comfortable with, and now that your stocks comprise 95% of your portfolio, it's just a hair too risky for your liking. That's why you would rebalance. 

So in order to get back to your goal allocation of 90/10, you really have two options. You can sell stocks and use the money to buy bonds, or if you're still contributing and growing your account, 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 fortified. Which option makes more sense is really gonna depend on the size of your portfolio and where your assets are, which accounts they are in. If you have $500,000 and you need to get your bond allocation up by $25k to help get things back in line with your original goal, that might take awhile, and you probably don't wanna stop investing completely in stocks in the meantime if you are a dollar cost averaging queen, so in this scenario, you may decide to venture over to, say, a 401(k) that's a little beefy and offload some of your longest-held stocks to reinvest in bonds, or you may decide it's okay to realize some capital gains or losses in order to rebalance the way that you want to.

I'm gonna be really honest, though—I haven't rebalanced in earnest pretty much ever. I pretty much just let things ride, mostly because I'm still trying to be aggressive. So you may find yourself rebalancing specifically because you are starting to near retirement age and maybe you started investing in a 100% stock portfolio at 30 and now you're 50 and you're like, “Wait, this is way too aggressive for me.” So everyone will eventually age into the need to rebalance. And at that point you have a few considerations. 

Number one, we've already mentioned the first consideration, that you wanna try to rebalance as much as possible within tax-advantaged accounts where you're not gonna get dinged with capital gains taxes. And the second consideration is to just be mindful of the upper capital gains tax bracket, at which point you would creep into 20% territory. So if you're a high earner and/or you are selling a lot at once in order to rebalance, you wanna ensure that you don't accidentally breach the upper limit of the 15% bracket and begin paying 20% on some of your gains. That wouldn't be the end of the world, obviously, but it's good to avoid it if possible. And ideally, this is something that can be done little by little over time, rather than all at once. 

Now up until this point, we've mostly focused on how taxes apply when your holdings are up, but what if your stocks are down? Since 2022 was such a dumpster fire in the markets, it provided an opportunity (which has now passed, but hey, worth knowing for the future), to tax loss harvest. So you may have heard that phrase tossed around, and tax loss harvesting is effectively what happens when you say, “Hey, I invested a hundred dollars and now I only have $80, and I want to take a tax deduction on the $20 that I lost to help ease the pain of my failure.” I'm just kidding. You're not a failure; you're just an investor who's along for the ride, but 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 now or in the future.

The important part, however, is not that you're just cashing out and walking out of the stock market casino. You are reinvesting your $80 into something similar but not “substantially identical.” That is to say, 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, which is cap weighted US stocks, but you're also benefiting from the loss that you experienced. Unfortunately, you do have to sell by the last day of the year. So it's too late to do this for 2022 losses, but keep it in your back pocket in the future.

If you use a robo-advisor like Betterment, this happens automatically if you have the feature turned on. And remember, 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 anyway, like a 401(k). This is a bit of a tricky maneuver, though, for a few reasons. For one thing, you wanna 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. So 60 days total. 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. So to extend our earlier example, if I sold my S&P 500 holdings at a loss to repurchase 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 just carry them forward into the future to offset future you’s gains.

Should taxes scare you from investing? Well, would you turn down a raise because you're gonna have to pay taxes on the incremental money? No, probably not. Now, the discussion today is a pretty decent support case for maximizing your 401(k) and IRA contributions first, though, since the ongoing tax situation on those bad boys is pretty simple. And by simple, I mean you often don't have to do or pay anything each year until you start using the funds later in life, but you can buy and sell in those accounts with generally reckless abandon. But the point is, if you owe taxes on investment gains, that means you had investment gains and that is a beautiful thing.

Of course, there are ways to help minimize the pain. So 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. And then what can you expect at tax time? It's pretty simple. Most firms will send you something called a 1099-DIV by mid-February. This will list your capital gains, your ordinary dividends, your qualified dividends, your capital losses, and that's what you'll upload to your tax software of choice or give to a CPA.

Now, to give you a sense of scale, on an account that closed out 2022 with a total balance of around $110,000, I had $2,258 in total ordinary dividends and about $1,700 in qualified dividends. We pay the 35% marginal tax rate, but the 20% capital gains tax rate. So my $2,258 that gets taxed at my ordinary income tax rate, 35%, creates a $790 tax bill, and my $1,700 of qualified dividends gets taxed at 20% and generates a tax bill of around $350. I'll pay about $1,100 in taxes this year on those $4,000 of dividends in that investment account. Now, am I happy about paying $1,100? Well, no, but I'm still $3,000 ahead. Would I forgo a $4,000 gain because of an $1,100 loss? No. 

It's important to note that this account, one that I'm growing for the long term, is still hanging on to those reinvested dividends, right? That money is not cash in my pocket. This means I'll need to produce that cash from somewhere else to pay this portion of my tax bill. Keep this in mind when your taxable accounts start to grow to the point that your dividend yield generates a few hundred or a few thousand dollars in taxes every year that you're going to have to pay for.

In conclusion, even if this feels like a lot to manage yourself at tax time, you do have options. You can invest with a roboadvisor, because it's likely that they'll have automatic rebalancing and automatic tax loss harvesting features that you can turn on so you don't have to worry about it. And your 1099-DIV forms will spell out the results of each account for you. So get familiar with them. It is relatively easy to plug the numbers into tax software, but there's also no shame in hiring a CPA to handle it for you. They can answer questions and make suggestions that may lessen your tax burden, but in general, loading up on dividend-paying stocks and brokerage accounts that you intend to keep for the long haul will generally create more of a tax burden than necessary.

But that's the best news of all. If you're making enough income from your investments to be taxed on it, you are in Rich Girl territory. Embrace it. 

All right, y'all, that is all for this week. I will see you next week, same time, same place, on The Money with Katie Show. Our show is a production of Morning Brew and is produced by Henah Velez and me, Katie Gatti Tassin, with our audio engineering and sound design from Nick Torres. Devin Emery is our chief content officer and additional fact checking comes from Kate Brandt.

And don't forget, if you enjoyed the excerpts from today's episode of my conversation with Mark Jaeger from TaxAct, to visit my YouTube channel to hear the full conversation and learn even more tips to help you file confidently this year.