How State and Local Taxes Affect Your Investment Returns

When it comes to your investment returns, taxes can take a bigger bite than you might expect. Beyond federal taxes, state and local taxes (SALT) can also affect how much you actually keep. These extra layers of tax vary based on where you live and what types of investments you hold. That’s why understanding how the SALT deduction works is an important part of making tax-aware decisions. 

In this guide, we’ll discuss how different states treat investment income, how the SALT cap may apply, and what factors to consider if you’re looking to improve your after-tax returns.

Why State and Local Taxes Matter

State and local taxes, often referred to as SALT, include the taxes you pay to your state or local government that might qualify as itemized deductions on your federal return. These are reported on Schedule A (Form 1040).

Here’s what typically qualifies:

✅ State and local income taxes or general sales taxes (only one may be claimed)

✅ Real-estate taxes paid to state or local governments

✅ Personal property taxes based on the assessed value of a items like cars or boats 

You can only deduct either income or sales taxes, not both. Choosing the one that generally gives you the bigger deduction is usually the way to go.

That said, the SALT deduction is limited to $10,000 per year ($5,000 if married filing separately). This cap may reduce the tax benefit for those living in states with higher tax rates.

For investors, state taxes may apply to:

📝 Tip: Knowing which taxes qualify and how the cap works can help you better estimate what you actually keep after taxes.

How Your State Impacts Returns

Each state has its own rules on how it taxes investment income. According to the Federation of Tax Administrators roster of 2025 state rates, most states classify interest, dividends, and capital gains as ordinary income and tax them at the same rate as wages. 

A few states impose no personal income tax at all, which may leave investors with higher after-tax returns than identical portfolios held in high-tax states, especially once the federal SALT cap is fully used.

Interest on municipal bonds issued by your home state is usually exempt from that state’s income tax; interest from out-of-state bonds may remain taxable. The exemption is outlined in IRS Publication 550.

✅ Quick Check Before You Invest

Answering these questions upfront may help align your portfolio’s expected returns with its likely after-tax outcome.

Tax Rules by Investment Type

Different assets follow different tax rules. Knowing the basics helps you estimate potential after-tax returns and spot opportunities to improve your overall strategy.

Stocks & ETFs

Stocks and exchange-traded funds follow the familiar federal capital-gain and dividend rules, and most states start with those same numbers.

✅ Short-term gains (held one year or less) are typically taxed as ordinary income at both the federal and state level.

✅ Long-term gains (held more than one year) may qualify for lower federal rates (0%, 15%, or 20%) but are often taxed as ordinary income by states.

✅ Dividends

📝 Reinvesting dividends does not defer the tax; the amount still counts as income and increases your cost basis.

Municipal Bonds

Interest from municipal bonds receives special federal treatment and may lower your state tax bill if you buy bonds issued within your home state.

✅ Federal exemption: Interest on most municipal bonds is exempt from federal income tax.

✅ Home-state exemption: When the bond is issued in your state of residence, the interest is often exempt from that state’s tax too.

❗ AMT watch: Interest from certain private-activity bonds may be subject to the alternative minimum tax.

📝 Note: Selling a muni at a gain still triggers capital-gain rules just like a stock sale.

REITs & Other Pass-Through Assets (Optional)

Real estate investment trusts (REITs) and similar pass-through vehicles distribute most of their earnings rather than reinvesting them, so the tax rules differ from those for common stocks.

✅ Dividend treatment: REIT dividends are usually taxed as ordinary income because they do not meet the “qualified” test.

✅ Section 199A deduction: Up to 20 percent of “qualified REIT dividends” may be deductible for eligible taxpayers, subject to income limits. See the IRS page on the qualified business income deduction for details.

❌ No dividends-received deduction: C-corporations generally cannot use the DRD for REIT payouts.

📝 Note: Long-term gains on REIT shares, as well as capital-gain distributions from the REIT, normally receive the same rates that apply to long-term stock gains.

📌 Also Read: What is a Gift Tax (Rates, Limits, How It Works)

Ways to Cut Down SALT Costs

Below are three tactics investors typically consider when trying to trim state-and-local tax (SALT) drag on portfolio earnings:

✅ Park tax-heavy assets inside retirement accounts
Holding bond funds, high-turnover stock strategies, or other income-generating investments in a 401k or traditional IRA could postpone state and local tax until money is withdrawn. Contributions may also reduce current taxable income if the plan meets IRS rules.

✅ Harvest losses to offset gains
Selling positions that are below cost and reinvesting in a similar—but not identical—security may allow you to apply those losses against capital gains. Up to $3,000 of net losses generally reduces ordinary income each year, with any excess carried forward.

✅ Consider a pass-through entity tax (PTET) election
In many states, partnerships and S-corps can elect to pay income tax at the entity level. Because that payment is deductible to the business, it generally bypasses the $10,000 SALT cap on individual returns. IRS Notice 2020-75 confirms the federal deductibility, yet each state sets its own rules, so professional guidance is usually advisable.

Next Steps

State and local taxes are often overlooked, but they may play a meaningful role in shaping your actual investment returns. Understanding how your state treats investment income, and how the SALT deduction cap applies, could help you make more informed decisions. 

If you’re aiming to reduce tax drag, consider reviewing your portfolio’s asset placement, exploring PTET options if you’re self-employed, and running a projection using a tax calculator.

✅ Start with the IRS Tax Withholding Estimator to get a general sense of your tax situation.
✅ Look into PTET programs available in your state.
✅ If you’re unsure how state and local taxes apply to your situation, it may be helpful to speak with a qualified tax professional.

Planning around SALT doesn’t guarantee better returns and won’t eliminate taxes entirely, but it can help reduce the drag on your investment performance. With a few well-placed adjustments, you may keep more of what your portfolio earns.

📌 Not sure where to go next? Take a look at our other articles on tax strategies, investment planning, and retirement account options:

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