There are several ways investment income is taxed: You may be familiar with capital gains taxes — the taxes imposed when one sells an asset that has gained value — but it’s important to also understand the tax implications of dividends, interest, retirement account withdrawals, and more.
In some cases, for certain types of accounts, taxes are deferred until the money is withdrawn, but in general tax rules apply to most investments in one way or another.
Being well aware of all the tax liabilities your investments hold can minimize headaches and help you avoid a surprise bill from the IRS. Being tax savvy can also help you plan ahead for different income streams in retirement, or for your estate.
Types of Investment Income Tax
There are several types of investment income that can be taxed. These include:
• Capital Gains
• Interest Income
• Net Investment Income Tax (NIIT)
Taking a deeper look at each category can help you assess whether — and what — you may owe.
Tax on Dividends
Dividends are distributions that are sometimes paid to investors who hold a certain type of dividend-paying stock. Dividends are generally paid in cash, out of profits and earnings from a corporation.
• Most dividends are considered ordinary (or non-qualified) dividends by default, and these payouts are taxed at the investor’s income tax rate.
• Others, called qualified dividends because they meet certain IRS criteria, are typically taxed at a lower capital gains rate (more on that in the next section).
Generally, an investor should expect to receive form 1099-DIV from the corporation that paid them dividends, if the dividends amounted to more than $10 in a given tax year.
More About Capital Gains Tax
Capital gains are the profit an investor sees when an investment they hold gains value when they sell it. Capital gains taxes are the taxes levied on the net gain between purchase price and sell price.
For example, if you buy 100 shares of stock at $10 ($1,000 total) and the stock increases to $12 ($1,200), if you sell the stock and realize the $200 gain, you would owe taxes on that stock’s gain.
There are two types of capital gains taxes: Long-term capital gains and short-term capital gains. Short-term capital gains apply to investments held less than a year, and are taxed as ordinary income; long-term capital gains are held for longer than a year and are taxed at the capital-gains rate.
For 2022 and 2023, the capital gains tax rates are typically no higher than 15% for most individuals. Some individuals may qualify for a 0% tax rate on capital gain — but only if their taxable income is $83,350 or less (married filing jointly), or $41,675 or less for single filers and those who are married filing separately.
The opposite of capital gains are capital losses — when an asset loses value between purchase and sale. Sometimes, investors use losses as a way to offset tax on capital gains, a strategy known as tax-loss harvesting.
Recommended: Is Automated Tax-Loss Harvesting a Good Idea?
Capital losses can also be carried forward to future years, which is another strategy that can help lower an overall capital gains tax.
Capital gains and capital losses only become taxable once an investor has actually sold an asset. Until you actually trigger a sale, any movement in your portfolio is called unrealized gains and losses. Seeing unrealized gains in your portfolio may lead you to question when the right time is to sell, and what tax implications that sale might have. Talking through scenarios with a tax advisor may help spotlight potential avenues to mitigate tax burdens.
Taxable Interest Income
Interest income on investments is taxable at an investor’s ordinary income level. This may be money generated as interest in brokerage accounts, or interest from assets such as CDs, bonds, Treasuries, savings accounts.
One exception are investments in municipal (muni) bonds, which are exempted from federal taxes and may be exempt from state taxes if they are issued within the state you reside.
Interest income (including interest from your bank accounts) is reported on form 1099-INT from the IRS.
Tax-exempt accounts, such as a Roth IRA or 529 plan, and tax-deferred accounts, such as a 401(k) or traditional IRA, are not subject to interest taxes.
Net Investment Income Tax (NIIT)
The Net Investment Income Tax (NIIT), now more commonly known as the Medicare tax, is a 3.8% flat tax rate on investment income for taxpayers whose adjusted gross income (AGI) is above a certain level — $200,000 for single filers; $250,000 for filers filing jointly. Per the IRS, this tax applies to investment income including, but not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, and income from businesses involved in trading of financial instruments or commodities.
For taxpayers with an AGI above the required thresholds, the tax is paid on the lesser of the taxpayer’s net investment income or the amount the taxpayer’s AGI exceeds the AGI threshold.
For example, if a taxpayer makes $150,000 in wages and earns $100,000 in investment income, including income from rental properties, their AGI would be $250,000. This is $50,000 above the threshold, which means they would owe NIIT on $50,000. To calculate the exact amount the taxpayer would owe, one would take 3.8% of $50,000, or $1,900.
One way to mitigate the effects of investment income is to create a set of tax efficient investing strategies. These are strategies that can minimize the tax hit that you may experience from investments and allow you to grow your wealth. These strategies can include:
• Diversifying investments to include investments in both tax-deferred and tax-exempt accounts. An example of a tax-deferred account is a 401(k); an example of a tax-exempt account is a Roth IRA. Investing in both these vehicles may be a strategy for long-term growth as well as a way to ensure that you have taxable and non-taxable income in retirement.
Remember that accounts like traditional, SEP, SIMPLE IRAs, as well as 401(k) plans and some other employer-sponsored accounts, are tax-deferred — meaning that you don’t pay taxes on your contributions the year you make them, but you almost always owe taxes whenever you withdraw these funds.
• Exploring tax-efficient investments. Some examples are municipal bonds, exchange-traded funds (ETFs), Treasury bonds, and stocks that don’t pay dividends.
• Considering tax implications of investment decisions. When selling assets, it can be helpful to keep tax in mind. Some investors may choose to work with a tax professional to help offset taxes in the case of major capital gains or to assess different strategies that may have a lower tax hit.
Investment gains, interest, dividends — basically any money you make from securities you sell — can be subject to tax. But the tax rules for different types of investment income vary, and you also need to consider the type of account the investments are in.
Underreporting or ignoring investment income can lead to tax headaches and may result in you underpaying your tax bill. That’s why it’s a good idea to keep track of your investment income, and be mindful of any profits, dividends, and interest that may need to be reported even if you didn’t sell any assets over the course of the year.
Some investors may find it helpful to work with a tax professional, who can help them see the full scope of their liabilities and help them become aware of potential investment strategies that could help them minimize their tax burden, especially in retirement. A tax advisor will also be aware of any specific state tax rules regarding investment taxes.
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