Understanding How Investment Returns Are Taxed

Updated for 2025

As Benjamin Franklin famously said:

“In this world, nothing can be said to be certain, except death and taxes.”

As the IRS tax filing deadline approaches, many of us become keenly aware of and curious about how we are being taxed.

Not all money is taxed the same. Not all investment returns are taxed the same. 

We know taxes can play a crucial role in investment decisions, affecting overall returns and wealth accumulation; understanding how different types of investment returns are taxed can help you manage your investments more efficiently and optimize your after-tax income.

As fiduciary advisors, we take the upmost care and time to evaluate investments and financial planning strategies to benefits our clients.

What Is a Capital Asset?

Nearly everything you own—whether for personal use or investment—is considered a capital asset. Common examples include your home, household items like furniture, and investment holdings such as stocks and bonds.

When you sell a capital asset, the difference between what you paid for it (your cost basis or adjusted basis) and the amount you sold it for is either a capital gain or a capital loss:

• If you sell it for more than your adjusted basis, you have a capital gain.
• If you sell it for less, you have a capital loss.

Note: The adjusted basis is typically what you originally paid for the asset. However, if you received the asset as a gift or through an inheritance, the basis rules differ.

Importantly, losses from the sale of personal-use property (like your home or car) cannot be deducted on your tax return.

Short-Term vs. Long-Term Gains

Capital gains and losses are classified as either short-term or long-term, and this classification affects how much tax you may owe. 

• If you hold the asset for more than one year before selling, the gain or loss is considered long-term.
• If you hold the asset for one year or less, it’s a short-term gain or loss.

To calculate your holding period, count from the day after you acquire the asset to the day you sell it, including that final day.

Exceptions: Special rules may apply for assets received as gifts or inheritances, or for certain types of property like patents, commodity futures, or interests in partnerships. 

What Is a Net Capital Gain or Loss?

At the end of the year, your gains and losses are added together to determine your net capital gain or loss. This figure can affect your tax rate:

• A net capital gain occurs when your net long-term capital gains exceed your net short-term capital losses.
• A net long-term capital gain is your total long-term gains minus long-term losses (including any losses carried over from prior years).
• A net short-term capital loss is the amount by which your short-term losses exceed short-term gains (including any carryovers from prior years).

If you end up with a net capital gain, it may be taxed at lower rates than your ordinary income—especially if the gains are long-term. 

Brokers must report whether the investment gain or loss is short-term or long-term on FORM 1099-B.

Federal Long-Term Capital Gains Tax Brackets and Rates for 2025 (realized in 2025)

Federal Income Tax Brackets and Rates for 2025 (earned in 2025)

Interest Income

Like short-term capital gains, interest income is taxed as ordinary income at the marginal tax rate. This applies to:

• Interest on bank accounts, money market accounts, certificates of deposit (CDs), corporate bonds and deposited insurance dividends
• Interest income from US Treasury bills, notes and bonds
• Savings bond interest and other interest.

However, municipal bonds offer tax advantages. Interest earned from municipal bonds is typically exempt from federal income tax and may also be exempt from state taxes if the bondholder resides in the issuing state. Be mindful, though—some municipal bonds may trigger Alternative Minimum Tax (AMT) implications.

Interest income is reported to taxpayers on Form 1099-INT or Form 1099-OID. If total interest and dividends exceed $1,500, taxpayers are additionally required to report it to the IRS in Schedule B (Form 1040).

Ordinary vs. Qualified Dividends

Dividends are payments made by a corporation to its shareholders—typically as a way to share profits. If you own stock in a company, you may receive dividends, most commonly in the form of cash. 

Ordinary cash dividends, such as those issued by Real Estate Investment Trusts (REITs) and non-qualifying C-corporations, are considered ordinary income and taxed at marginal tax rates—the same rates applied to wages and interest income.

Certain dividends, qualified dividends, benefit from the same preferential tax rates as long-term capital gains. The dividends of most American companies are qualified dividends. To qualify:

1. The dividend must be issued by a U.S. corporation or a qualified foreign corporation.
2. The stock must be held for more than 60 days within the 121-day period beginning 60 days before the ex-dividend date.

For investors in the 15% or 20% long-term capital gains brackets, qualified dividends offer significant tax savings over ordinary dividends.

It’s important to note that all reinvested dividends (DRIP) are taxed.

If you received at least $10 in dividends (ordinary and qualified) from any payer, you should receive Form 1099-DIV. If total interest and dividends exceed $1,500, taxpayers are additionally required to report it to the IRS in Schedule B (Form 1040).

Taxes Aren’t Everything

While tax efficiency is essential, investment decisions should prioritize asset allocation over tax considerations. A well-balanced portfolio aligned with financial goals will often yield better long-term results than one focused solely on minimizing taxes.

As Warren Buffett wisely put it:

“Don’t let the tax tail wag the investment dog.”

Understanding these tax treatments can help you structure your investment strategy for maximum efficiency. Always consult with a tax professional and financial advisor to optimize your individual financial plan.

Sources:

https://www.irs.gov/taxtopics/tc409

https://www.irs.gov/taxtopics/tc404

https://www.irs.gov/taxtopics/tc403