Understanding income tax and capital gains tax is crucial in financial planning. These types of taxes differ in their types, calculations, and impacts on investment returns. Here’s what investors need to know about each to make more informed decisions.

How Income Tax Works

Income tax is a direct tax imposed by governments on the financial income generated by all entities within their jurisdiction. Individuals, businesses, and corporations are obligated to pay this tax. Income tax rates are typically progressive, meaning the more one earns, the higher the tax rate. Income tax consists of:

· Ordinary income - This includes wages, salaries, commissions, and interest income. It is generally taxed at regular, progressive tax rates.

· Passive income - Income derived from rental activity, limited partnerships, or other enterprises in which the individual does not actively participate. It may be subject to the 3.8% net investment income tax (NIIT) for taxpayers with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly).

How Capital Gains Tax Works

Capital gains tax is a tax levied on profits from the sale of an asset, such as stocks, bonds, or property. The tax applies when an asset is sold for more than it was bought for, with the difference constituting the "capital gain." This gain can be either short-term (held for one year or less) or long-term (held for more than one year), and each carries different tax implications.

· Short-term capital gains - Gains on assets held one year or less are taxed at ordinary income tax rates.

· Long-term capital gains - Gains on assets held more than one year are generally taxed at federal rates of 0%, 15%, or 20%, depending on taxable income. Qualified dividends receive the same rates. Higher earners may also owe the 3.8% NIIT.

In Arizona, capital gains are generally taxed at the state's flat income tax rate (2.5% as of 2026), though a partial subtraction may be available for certain long-term gains.

How Taxes Affect Investment Returns

Income taxes - Income taxes can affect one's ability to save and invest. High income taxes may reduce disposable income, thereby reducing the funds available for investing. Investments are taxed at the investor's income tax rate, thereby reducing the investment's net return.

Capital gains tax - Capital gains tax can deter investors from selling profitable investments, prompting them to hold assets longer to qualify for a lower long-term capital gains tax rate. This holding-period strategy, known as 'tax-loss harvesting,' can potentially help reduce taxable income. However, tax-loss harvesting may not be appropriate for all investors, and its effectiveness depends on your individual tax bracket and investment portfolio.

Strategies to Help Manage Investment Taxes

· Tax-loss harvesting – Selling investments at a loss can offset realized capital gains, and up to $3,000 of net capital losses per year can offset ordinary income, with any excess carried forward. The wash-sale rule disallows the loss if a substantially identical investment is purchased within 30 days before or after the sale.

· Holding period – Holding appreciated investments for more than one year may qualify gains for lower long-term rates.

· Asset location – Holding tax-inefficient investments, such as those generating interest income, in tax-deferred accounts like IRAs and 401(k)s may help reduce annual taxes.

Tax-loss harvesting and other tax strategies may not be appropriate for all investors, and results depend on individual circumstances.

Investment Tax FAQs

What's the difference between short-term and long-term capital gains?

Short-term gains come from assets held one year or less and are taxed at ordinary income rates. Long-term gains come from assets held more than one year and generally qualify for lower federal rates of 0%, 15%, or 20%.

What is tax-loss harvesting?

Tax-loss harvesting is selling investments at a loss to offset capital gains and, up to $3,000 per year, ordinary income. Investors must avoid buying a substantially identical investment within 30 days before or after the sale.

Understanding both income and capital gains taxes is important for strategic tax planning. A financial professional can help you evaluate tax-efficient strategies that align with your goals and risk tolerance, whether as part of a mid-year tax review or ongoing portfolio management.