How are different types of investment income taxed?
Investment taxation depends on the type of income: Qualified dividends and long-term capital gains are taxed at preferential rates (0%, 15%, or 20%). Short-term gains and ordinary dividends are taxed as ordinary income. Interest income is generally taxed as ordinary income (except municipal bond interest, which is often tax-free).
Understanding investment taxation helps you keep more of what you earn. Let me break down the categories.
Long-term capital gains (assets held 1+ year):
- 0% for income up to ~$44,000 (single) / ~$89,000 (married)
- 15% for income up to ~$492,000 (single) / ~$553,000 (married)
- 20% for income above those thresholds
- Plus 3.8% Net Investment Income Tax for high earners
Short-term capital gains (assets held less than 1 year):
- Taxed as ordinary income (up to 37%)
- This is why we generally prefer holding investments long-term
Qualified dividends:
- Same preferential rates as long-term capital gains
- Must meet holding period requirements
- Most US stock dividends qualify
Ordinary dividends:
- Taxed as ordinary income
- REITs, some foreign stocks, money market funds
Interest income:
- Taxed as ordinary income
- Bank interest, corporate bonds, Treasury bonds (federal, not state)
- Municipal bonds are generally tax-free (federal and often state)
Tax-efficient location:
Different accounts have different tax treatment:
- Taxable accounts: Best for buy-and-hold investments with qualified dividends
- Traditional IRA/401(k): Good for bonds (converts to ordinary income anyway)
- Roth IRA: Best for highest-growth investments (tax-free growth)
The planning opportunity: Asset location—holding the right investments in the right accounts—can add 0.25-0.50% to after-tax returns annually. That adds up over decades.
This is why comprehensive planning matters. It's not just what you own, but where you own it.