New to investing? Know these tax basics


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Taxes on investment income can be confusing, especially since there are several ways investment income is taxed. An investor may be familiar with capital gains taxes—the taxes imposed when one sells an asset that has grown—but less clear on the implications of dividends, interest and other ways in which investments have tax implications.

Certain types of investment vehicles—529 plans, retirement plans like 401(k)s and IRAs—are either not taxed until money is taken out of the account, or may not ever be taxed, depending on the reason and timing for taking money from the account. But general investing accounts come with tax liabilities.

Being well aware of all the tax liabilities your investments hold can minimize headaches and help you avoid a surprise bill from the IRS. Working with a professional can be helpful as an investor’s portfolio grows, or as they find themselves selling assets to fund a purchase, like the down payment on a home. But for all investors, it makes sense to familiarize yourself with the different types of taxes on investment income and some potential strategies investors use to limit taxes.

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Types of Investment Income Tax

There are several types of taxes on investments. These include:

  • Dividends
  • Capital Gains
  • Interest Income
  • Interest income
  • Net Investment Income Tax (NIIT)

Taking a deeper look at each category can help you assess whether—and what—you may owe.

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1. Tax on Dividends

Dividends are distributions that are sometimes paid to investors who hold a stock or otherwise have an interest in a partnership, trust, S-corp or other entity taxable as a corporation. Dividends are generally paid in cash, out of profits and earnings from a corporation.

Some dividends are ordinary dividends, and are taxed at the investor’s income tax rate. Others, called qualified dividends, are typically taxed at a lower capital gains rate (more on that in the next section). Briefly, the distinction between the two is that stocks that are held for a short period of time are typically subject to a higher tax rate, while stocks held for a longer period of time are typically subject to the lower tax rate. For the full details, the IRS offers information on qualified and non-qualified dividends .

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.

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2. More About Capital Gains Tax

Capital gains are the profit an investor makes between the price of an asset when purchased, versus the price of an asset when sold. Capital gains taxes are the taxes levied on the net gain between purchase price and sell price.

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 2021, the
IRS rates are no higher than 15% for most individuals, $0 if your taxable income is less than $80,0000)

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 implications of capital gains. 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, 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.

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3. Taxable Interest Income

Interest income on investments are taxable at an investor’s ordinary income level. This may be money generated as interest in brokerage accounts or interest from assets, such as bonds or mutual funds. The only 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.

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4. 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. As 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.

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Tax-Efficient Investing

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 these vehicles may be a strategy for long-term growth as well as a way to ensure that money is earmarked for certain purposes. While these are commonly thought of as retirement vehicles, there are other times when they may be tapped. For example, funds in a Roth can be used for qualified education expenses.
  • Exploring tax-efficient investments. Some examples are municipal bonds, exchange-traded funds (ETFs), treasury bonds, and stocks that do not 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.

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The Takeaway

Underreporting or ignoring investment income can lead to tax headaches and may result in a taxpayer underpaying their overall tax bill. That’s why it’s a good idea to keep track of your investment income, and be mindful of any dividends and interest that may need to be reported even if you didn’t sell any assets over the course of the year.

Because the tax code can be tricky, with different rules applying to different levels, familiarizing yourself with different types of taxes, analyzing any paperwork or forms you received, and asking questions well before filing can help you make sure you didn’t overlook any potential tax requirements when it comes to your investment portfolio.

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. A tax advisor will also be aware of any specific state tax rules regarding investment taxes.

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