Investment income is a significant part of many taxpayers’ income and it's important to understand how it's taxed.
What is investment income? In essence, it’s interest, dividends, and capital gains and it may be subject to taxation. The specific tax rate that applies to each type of investment income, however, depends on several factors, including the length of time the investment was held and the type of dividend received.
Here are some things taxpayers should know about how these types of income are taxed:
Interest income
Most interest income is taxed at ordinary income tax rates. So, for instance, if you received $50 of interest income from a $1,000 certificate of deposit, you would pay taxes on that along with your other income.
However, some interest income, such as interest from municipal bonds, may be exempt from federal and state tax. Interest earned on U.S. Treasury bonds, notes, bills, savings bonds, and Treasury Inflation Protected Securities (TIPS) are taxed as ordinary income for federal purposes but are not taxed for state purposes.
What’s more, taxpayers with investment income and modified adjusted gross income above a certain threshold may owe a Net Investment Income Tax, or NIIT. NIIT is a 3.8% tax on certain types of investment income for individuals, estates, and trusts with income above certain thresholds. Net investment income includes interest, dividends, rental income, capital gains from the sale of investment assets, and certain types of passive income from businesses. The NIIT depends on the taxpayer's filing status.
Your taxes, your way. Do it yourself, get expert help, or hand it off start to finish. Get your taxes done right and save up to $20 on TurboTax online federal products.
Interest income is typically reported to the taxpayer on Form 1099-INT, Interest Income. This form is issued by the payer of the interest, such as a bank, credit union, or brokerage firm, and it shows the amount of interest you received, the type of interest, and the payer's tax identification number as well as other details.
Another IRS form that may be used to report interest income is the Form 1099-OID, (Original Issue Discount.)
Dividends
Dividends are payments made by a company, as well as by many mutual funds, to its shareholders from its earnings. They are typically paid out quarterly, but some companies may pay them more or less frequently.
There are ordinary dividends, and a subset of ordinary dividends called qualified dividends. Ordinary dividends are taxed at ordinary income tax rates of up to 37%. Qualified dividends are taxed at lower capital gains tax rates, which can range from 0% to 20%.
Form 1099-DIV is used by financial institutions to report dividends and certain other distributions to taxpayers and to the IRS. That form shows the amount of the dividend, the type of dividend, and the payer's tax identification number.
Here is a table that summarizes the tax treatment of dividends:
| Type of Dividend | Tax Rate |
|---|---|
Ordinary Dividend |
Ordinary income tax rates (up to 37%) |
Qualified Dividend |
Lower capital gains tax rates (0% to 20%) |
Reporting interest and dividend income
If you received more than $1,500 in interest income and/or ordinary dividends in a year, you must report it on your tax return, using Schedule B. You can do this by attaching Schedule B to your return or by entering the information from the form directly into your tax software.
If you earn $1,500 or less in total interest (and dividend) income during the year, you still have to include those amounts on your tax return even though you don't file a Schedule B.
Capital gains
Capital gains occur when an asset increases in value between when it is purchased and when it is sold. The tax treatment of capital gains depends on how long the asset was held.
Short-term capital gains are gains on assets held for one year or less. Short-term capital gains are taxed at the same rates as ordinary income, which can be up to 37%.
Long-term capital gains are gains on assets held longer than one year. Long-term capital gains are typically taxed at lower rates than ordinary income, which can range from 0% to 20%.
Taxpayers can offset capital gains with capital losses. You can reduce your capital gains by the amount of your capital losses. Up to $3,000 of excess capital losses can be used to reduce ordinary income. Any additional capital losses can be carried over to subsequent years to offset future capital gains or up to $3,000 of ordinary income per year until all of the excess losses have been used.
Here are two examples of how capital gains and losses are taxed:
- Suppose you sell an asset for $10,000 that you bought for $5,000. This would result in a capital gain of $5,000. If you held the asset for more than one year, the capital gain would be taxed at a long-term capital gains rate of 0%, 15%, or 20%, depending on your income.
- Suppose you sell an asset for $5,000 that you bought for $10,000. This would result in a capital loss of $5,000. You use the loss to offset capital gains and any excess amount to reduce ordinary income by up to $3,000. Any excess capital loss can be carried forward to future years.
Capital gain and loss transactions are typically reported to the taxpayer on Form 1099-B (Proceeds from Broker and Barter Exchange.) This form is issued by the brokerage firm or other financial institution that processed the transaction.
The taxpayer would use Schedule D (Form 1040), Capital Gains and Losses to report capital gains on their tax return. It is a two-part form, with Part I used to report short-term capital gains and losses, and Part II used to report long-term capital gains and losses.
Bottom line
"The taxation of income from interest, dividends, and both short and long-term capital gains can be complex,” said Mitchell Freedman, CPA/PFS, the founder and president of MFAC Financial Advisors. “There may be different rules for federal and state purposes. There may also be different rates for federal purposes, based upon your highest incremental tax bracket.”
If your state of residency has no income tax, then that's one less concern, Freedman said. “But if it does, especially if it is a high-tax state, then an understanding of the intricacies and inter-relationships of the taxation is important,” he said.
By way of example, Freedman noted that some sources of interest income may be taxed for both federal and state purposes, some may only be taxed for federal purposes, and some only for state purposes.
“As if that isn't complex enough, when structuring an investment portfolio, the three most important things are: diversification; diversification; and diversification,” Freedman said.
“Therefore, while it is important to understand the effects of taxation on interest, dividends, and short- and long-term capital gains, I advise investors when it comes to the tax issues, ‘don't let the tax-tail wag the investment-decision dog,’” he said. “Investors must keep in mind that the taxation of their investments is only one part of the decision tree when structuring a portfolio.”
Learn more about how investment income is taxed by visiting the IRS website.
Editor's Note: The content was reviewed for tax accuracy by a TurboTax CPA expert for the 2022 tax year.
Robert Powell is editor and publisher of Retirement Daily on TheStreet.
