The income that investments pay investors is a great thing. Dividends are essentially free money to investors as we get “paid” for investing in certain stocks. Capital gains are a nice bonus at the end of the quarter or year that allows us to enjoy the benefits of a rising stock market or smart moves by the fund manager.
The downside of investment income is that it is taxable. Ahh, taxes. We just can’t avoid them no matter what. Luckily, investment income is taxed at different levels and in many cases, at a lower rate than ordinary income. Below is a basic guide to how investment income is taxed. This guide won’t cover everything related to investment income and taxes 100%, so it makes sense to talk to your accountant about any of this in detail. Plus, Congress likes to change the tax code almost annually so things are always changing. With that said, I hope that this guide will give you an idea of how to invest your money smarter and in doing so, pay less taxes.
What is Ordinary Income?
Before we get into the various forms of investment income, I need to define for you what ordinary income is as I will be using that term throughout this post. Ordinary income is what the IRS deems to be income that gets taxed at the tax rates you see everywhere. So your paycheck is considered ordinary income. Likewise, some investment income is also considered ordinary income. When the term ordinary income is used, it is taxed at your income tax rate. If you are in the 25% tax bracket, then your ordinary income is taxed at 25%. Read more: How Do Tax Brackets Work?
Bond Interest and Savings Account Interest
I am lumping together these two since the income you earn from each of these investments is taxed at ordinary income levels. This means that the monthly interest you earn on your savings accounts, the interest you earn on your certificate of deposit, and the income you earn on your bonds is taxed at your current income tax rate, whichever bracket you are in.
For example, let’s say you earn $1,000 in bond interest in 2013 and are in the 25% tax bracket. In this case, $250 of your $1,000 will go to taxes.
If you invest in bonds, which you should be if you have a diversified portfolio, try to keep your taxable bond holdings in your retirement accounts. This is because your retirement accounts are “tax deferred” meaning you don’t pay taxes on the income until you take the money out. In other words, the bond income you earn can grow tax free. Note that this isn’t saying your retirement accounts should be 100% in bonds, but rather that the majority of the bonds you own should be in your retirement account to save on taxes.
Your non-taxable bond holdings, such as treasuries can be held in your taxable accounts since the interest earned on these bonds is tax free.
As of this writing, there are two types of dividends: ordinary dividends and qualified dividends. I am not going to go into detail about the two, just know that when you receive your 1099, it will break out the dividends there for you. Another reason I am not going into detail regarding these is because almost every year, Congress debates about getting rid of qualified dividends. There is good chance the idea of qualified dividends will be history in the coming years.
Dividend tax rate: In any case, the term ordinary dividend should set a light bulb off in your head. After all, the term ordinary is in the name. As you might have guessed, ordinary dividends are taxed at your ordinary income tax rate.
Qualified dividends on the other hand, are taxed at a lower rate. As of this writing, if you are in the 10 or 15% tax brackets, you pay no tax on qualified dividends. For all other tax brackets (excluding the 39.6% bracket), qualified dividends are taxed at the 15% tax rate. If you find yourself in the highest tax bracket, 39.6%, qualified dividends are taxed at 20%.
When it comes to capital gains, there are two types: short-term capital gains and long-term capital gains. Short-term capital gains are gains on investment shares you have held for less than one year while long-term capital gains are gains in investment shares you have held for more than one year.
It’s important to understand that we are talking about shares here and not the entire investment as a whole. If you owned shares in ABC mutual fund for 5 years but bought more shares in 2013, and then sold out of the investment in 2014, you could potentially have both short-term and long-term capital gains.
Capital Gains tax rate: For tax purposes, short-term capital gains are taxed at your ordinary income tax rate. Long-term capital gains have a lower tax rate. Currently, there is no tax on long-term capital gains if you are in the 10 or 15% tax brackets. The long-term capital gains rate for all other income tax brackets (except for the 39.6% bracket) is 15%. For the highest tax bracket, the long-term capital gains rate is 20%.
When it comes to capital losses, there is no tax owed. Instead, you get to write-off the losses against any gains you have realized over the course of the year, with a maximum limit of $3,000. The nice part about this is that if you have losses greater than $3,000, you don’t lose the loss. You can carry it forward indefinitely.
So, if you have a capital loss of $5,000 in 2013, you can write off $3,000 of that loss for 2013. In 2014, you can write off the remaining $2,000.
3.8% Investment Tax
Investment income tax rate: Lastly, we cannot forget to mention the 3.8% Investment Income Tax that results from the implementation of The Affordable Care Act. For in-depth details about this tax, be sure to read the post I wrote about it here. But in a nutshell, taxpayers that earn more than $250,000 per year (joint filers) or $200,000 (single filers) will pay an additional 3.8% tax on capital gains and dividends.
As I mentioned earlier, this was an introductory guide to taxes and investment income. There are many more nuances to taxes and investment income and the tax law is always changing. To be safe, you should talk to your accountant about your specific situation. But this guide can be a good start when thinking about your income, investing and how to limit the amount of tax you pay to Uncle Sam each year. You can also use our tax calculator to see the impact of the various investment taxes.