When most people think about investing, they focus on performance—how much a stock has gone up, what the bond market is doing, or how quickly their savings are compounding. But there’s another component that can have just as big an impact on your bottom line, and that’s taxes.
Every time you earn money from an investment, whether it’s from selling a stock at a profit, receiving dividends, or collecting interest, there’s a strong chance some of it will be taxed. And while a small tax bill here and there may not feel significant, over time, those payments can quietly erode the wealth you’re working so hard to build.
Let’s break it down.
How Investment Income Gets Taxed
Not all investment income is treated the same way. If you sell an investment at a profit, you’ll realize what’s called a capital gain. The rate you pay depends on how long you’ve held the investment. Short-term gains (less than a year) are taxed as ordinary income, while long-term gains often qualify for a lower, more favorable rate.
Dividends are another area where the rules vary. Some qualify for the lower capital gains tax rate, while others are taxed at ordinary income rates. Interest income, whether from savings accounts, CDs, or bonds, is almost always taxed at your regular income rate.
This variety means two investors could both earn $10,000, yet the amount they keep after taxes may differ significantly depending on how those earnings are categorized.
Why Taxes Matter for Long-Term Growth
The effect of taxes isn’t just about what you owe in the moment but how much you have left to reinvest. If you’re paying more to the IRS, you’re putting less back into your portfolio, which slows the power of compounding over time.
Consider two investors with identical $10,000 gains. One owes $3,000 in taxes and reinvests the remaining $7,000. The other uses tax-efficient strategies, owes only $1,500, and reinvests $8,500. That $1,500 difference, compounded year after year, could grow into a substantial wealth gap over decades.
Ways to Reduce the Tax Burden
The good news is that investors can take steps to keep more of what they earn. One of the most effective tools is using tax-advantaged accounts. A traditional 401(k) or IRA allows your investments to grow tax-deferred, with taxes due only when you withdraw funds later on. A Roth IRA, on the other hand, offers no immediate deduction but allows for tax-free growth and tax-free withdrawals in retirement.
Other strategies can also help. Tax loss harvesting, for example, involves selling investments that have declined in value to offset gains elsewhere, lowering your taxable income. Timing matters as well. Simply holding on to an investment long enough to qualify for long-term capital gains treatment can reduce the rate you pay. Even the placement of certain assets, known as asset location, can make a difference. By placing bonds, which generate regular taxable interest, in tax-deferred accounts and keeping tax-efficient index funds in taxable accounts, you can be more strategic.
Don’t Overlook State Taxes
Federal taxes may get most of the attention, but state taxes can also affect your net returns. Some states don’t tax investment income at all, while others apply an additional layer of taxes on top of what you owe federally. For retirees considering relocation or individuals splitting time between states, this is an important factor to include in long-term planning.
Keeping More of What You Earn
At the end of the day, investing isn’t just about how much you make but how much you keep. By planning with taxes in mind, you set yourself up to protect a greater portion of your earnings, reinvest them effectively, and give compounding the best chance to work in your favor.
If you’d like to review your portfolio and explore whether it’s set up in the most tax-efficient way, the team at WealthCrossing is here to help. Get in touch.
Disclosure
The information presented in this blog is for educational purposes only and should not be considered specific investment, tax, or legal advice. While the information is believed to be accurate as of the date of posting, no guarantee is made as to its completeness or accuracy. WealthCrossing is a registered investment advisor; we do not provide tax or legal services. Please consult with a qualified tax professional or attorney regarding your individual situation before making financial decisions.
