Investment income is taxed in a variety of ways – here's how to estimate what you'll owe and tips to minimize itFebruary 12, 2021
- Investment income can be taxed as ordinary income or at special rates, depending on the type it is.
- Capital gains and some dividends receive preferential tax rates. Interest and annuity payouts are taxed as ordinary income.
- All investments earn income tax-free while they remain in tax-advantaged accounts.
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You probably know that you have to pay taxes on just about all your income. But while the taxes on your work income is fairly straightforward — based on your tax bracket, and often automatically withheld from your paycheck — the tax on investment income can be more complex.
Not all investment income is taxed equally.
In fact, your investments are taxed at different rates, depending on the type of investment you have. Some investments are tax-exempt, some are taxed at the same rates as your ordinary income, and some benefit from preferential tax rates.
When you owe the tax can also vary. Some taxes are due only when you sell the investment at a profit. Other taxes are due when your investment pays you a distribution.
And finally, where you hold the investments matters. If the asset is in a tax-deferred account, such as an IRA, 401(k), or 529 plan, you won’t owe taxes on the earnings until you withdraw money from the account – or, depending on the type of account, ever.
See what we mean by complex? Never fear — here’s everything you need to know about the taxes on investment income, and the tax rates on different investments.
What is investment income?
Investment income comes in four basic forms:
- Interest income derives from the Interest earned on funds deposited in a savings or money market account, or invested in certificates of deposit, bonds or bond funds. It also applies to interest on loans you make to others.
- Capital gains. Capital gains come from selling an investment at a profit. When you sell an investment for less than you paid for it, it creates a capital loss, which can offset capital gains.
- Dividend income. If you own stocks, mutual funds, exchange-traded funds (ETFs), or money market funds, you may receive dividends when the board of directors of the company or fund managers decides to distribute the excess cash on hand to reward their investors.
- Annuity payments. When you purchase an annuity, a contract with an insurance company, you pay over a lump sum. The insurance company invests your money, and converts it into a series of periodic payments. A portion of these payments can be taxable.
Tax tip: Annual earnings or payouts from a pass-through entity, such as a master limited partnership or a limited partnership, or a rental property, or another business venture in which you’re not actively involved, is not investment income. It is considered passive income, which has its own tax rules.
How is investment income taxed?
With so many variables, how can you estimate the tax bite on your investments? Here are the tax rates for different types of investment income.
For the most part, interest income is taxed as your ordinary income tax rate – the same rate you pay on your wages or self-employment earnings. Those rates range from 10% to 37%, based on the current (2021) tax brackets.
Some interest income is tax-exempt, though. Interest from municipal bonds is generally tax-free on your federal return; when you buy muni bonds issued by your own state, the interest is exempt from your state income tax as well.
Another exception is granted US Treasury bonds, bills, and notes, as well as US savings bonds. They are exempt from state and local taxes, though not federal taxes.
The tax rate you’ll pay on capital gains depends on how long you owned the investment before selling it.
You have a short-term capital gain if you own the asset for one year (365 days) or less before selling it. Short-term capital gains are taxed at the same rate as your ordinary income.
You have a long-term capital gain if you hold on to the investment for more than one year before selling it. Long-term gains are taxed at preferential rates, ranging from 0% to 20%, depending on your total taxable income.
Capital gains are not taxable while the funds remain within a tax-advantaged IRA, 401(k), HSA, or 529 plan.
The rate you pay on dividends from stock shares or stock funds depends on whether the dividend is qualified or unqualified.
Qualified dividends are taxed at the same rates as long-term capital gains. Unqualified dividends are taxed at the same rates as ordinary income.
To count as qualified, you must have owned the dividend-producing investment for more than 60 days during the 121-day period that started 60 days before the security’s ex-dividend date. The ex-dividend date is the date after the dividend’s record date, which is the cut-off date the company uses to determine which shareholders are eligible to receive a declared dividend.
The taxation of annuity payments is a little more complex. While you may earn interest, dividends, and capital gains within your annuity, you don’t owe any taxes on this income until you actually start receiving your annuity payouts. You only have tax due on the sums you receive each year.
What you owe also depends on whether you purchased the annuity with pre-tax or after-tax dollars. If you purchase an annuity with pre-tax dollars (by rolling over money from your 401(k) or IRA), payments from the annuity are fully taxable.
But if you purchase an annuity with after-tax dollars — that is, you didn’t use retirement account money, you only pay taxes on the earnings portion of your withdrawal. The rest is considered a return of principal (the original lump sum you paid into the annuity).
When you receive your 1099-R from your insurance company showing your annuity payouts for the year, it will indicate the total taxable amount of your annuity income.
Whether you pay tax on 100% of the annuity payments or only the earnings portion of your withdrawal, all annuity payments are taxed at the ordinary-income rate.
How do I avoid taxes on investment income?
Most investment income is taxable, but there are a few strategies for avoiding – or at least minimizing – the taxes you pay on investment returns.
- Stay in a low tax bracket. Single taxpayers with taxable income of $40,400 or less in 2021 qualify for a 0% tax rate on qualified dividends and capital gains. That income limit doubles for married couples filing jointly. If you can take advantage of tax deductions that will keep your taxable income below that amount, you may be able to avoid paying taxes on a significant portion of your investment income.
- Hold on to your investments. Hanging on to stocks and other investments can help ensure you take advantage of preferential rates for qualified dividends and long-term capital gains.
- Invest in tax-advantaged accounts. Interest, dividends, capital gains — almost all forms of investment income are shielded from annual taxes while they remain in one of these accounts. With a traditional IRA or 401(k), the money is only taxable once you withdraw funds from the account. Money earned in a Roth IRA is never taxable, as long as you meet the withdrawal requirements. Interest income from a health savings account (HSA) or 529 plan is not taxable as long as you use the money to pay for qualified medical or educational expenses, respectively.
- Harvest tax losses. Tax loss harvesting involves selling investments that are down in order to offset gains from other investments. If you have investments in your portfolio that have poor prospects for future growth, it could be worth it to sell them at a loss in order to lower your overall capital gains. Many robo-advisors and financial advisors will take care of harvesting for you, trying to net out the winners and the losers.
The financial takeaway
A few tax-exempt assets aside, investment income is taxable. And it’s taxed in two basic ways: at ordinary income rates or at a lower preferential rate, generally known as the capital gains rate.
All assets accrue income tax-free while they remain in tax-advantaged accounts.
While it’s never a good idea to make investment decisions based solely on the tax implications, it is wise to consider the tax consequences of any investment moves you make. Taxes might not be the only reason you choose one investment over another, but tax breaks can be a bonus on any well-thought-out investment strategy.
Related Coverage in Investing:
Dividends are taxed in different ways — here’s how to figure what you owe on your stocks’ payouts
Interest income from your investments is taxable — here’s how to calculate what you owe and ways to lower it
Bitcoin taxes: Understanding the rules and how to report cryptocurrency on your return
Capital gains are the profits you make from selling your investments, and they can be taxed at lower rates
A variable annuity can provide you with more retirement income since its payouts rise with the stock market
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