How investment income gets taxed

Investment income is money you make from holding or selling financial assets. For example, you can earn investment income when you receive interest on a bond, sell a stock or sell your home. You can also earn it when you hold assets in a bank or credit union savings or money market account, a mutual fund or a brokerage account, among other investment vehicles.

Among the most common forms of investment income are interest, dividends and capital gains. Here’s an overview of all three and how each is taxed.

Interest

Typically, the IRS taxes interest at ordinary income tax rates of up to 37%. Some interest, such as interest earned on bonds issued by a state or local government, is generally exempt from federal, state and local tax. If a municipal bond was purchased from a state other than the purchaser’s state of residence, the home state will typically tax interest on the bond. Interest on U.S. Treasury bonds, notes and bills, as well as on Treasury Inflation-Protected Securities (TIPS), is taxed as ordinary income for federal purposes but is exempt from state and local taxes. The same rule applies to interest on U.S. savings bonds, but the savings bond owner can defer the federal tax liability until they cash in the bond, the bond matures or they relinquish the bond to another owner.

Taxable interest earned in an IRA or an account in a workplace retirement savings plan is tax-deferred until withdrawn or distributed from the account.

Dividends

Some individual stocks pay dividends to shareholders, typically on a quarterly basis, but the amount is not preset, and sometimes no dividend is paid at all. The amount is determined by the board of directors of the company that issued the stock. Sometimes, instead of approving a dividend, a company will reinvest profits in the company's growth or use profits to pay off debt.

There are two basic types of dividends, with each type subject to a different federal income tax rate:

• Ordinary dividends are payments made either by a company to owners of its common stock shares or by a mutual fund. Such dividends are taxed by the federal government at ordinary income tax rates of up to 37%.
• Qualified dividends are ordinary dividends that qualify for preferential tax rates because they’ve met IRS holding period requirements and were paid by either a US corporation or qualified foreign corporation.

Dividends earned in an IRA or an account in a workplace retirement plan are tax-deferred until withdrawn or distributed from the account. At that time, all taxable amounts withdrawn, including interest and dividends, will generally be taxed by the federal government as ordinary income.

Capital gains

A capital gain occurs when an asset, such as a home or an investment, increases in value between its purchase and its sale. The tax treatment of capital gains depends on whether they’re short-term or long-term gains:

• A short-term capital gain occurs when an asset is held for one year or less before being sold at a profit. Short-term capital gains are taxed at ordinary income tax rates.
• A long-term capital gain happens when an asset is held for more than one year before being sold at a profit. The tax rates for long-term capital gains are usually lower than ordinary income tax rates. The long-term capital gains rates are 0%, 15% and 20%; the rate you pay depends on your total taxable income for the year.

Capital gains distributions from mutual funds and exchange-traded funds. A capital gain distribution from a mutual fund or exchange-traded fund (ETF) will generally be taxable to you as a long-term capital gain for the year of distribution, regardless of whether the distribution was paid out to you or reinvested or how long you’ve owned shares of the fund. The gain can be offset by subtracting total losses from total gains for the year for tax purposes through a technique called “tax-loss harvesting.”

Additional tax on higher levels of investment income

Taxpayers whose net investment income exceeds certain thresholds will owe the 3.8% federal net investment income tax (NIIT) in addition to regular income tax on that income. The current net investment income thresholds that trigger the NIIT are $200,000 for single taxpayers and $250,000 for married taxpayers filing jointly. For NIIT purposes, investment income includes taxable interest, dividends and capital gains, among other things. Tax-exempt bonds are not subject to the NIIT.

It’s always a good idea to consult with a tax professional about your specific situation.