Investment income is taxed in a variety of ways – here’s how to estimate what you’ll owe and tips to minimize it

investment income
Your investment income may be taxed as ordinary income, at certain special rates, or not at all, depending on the type of investment it is and the sort of investment account it’s in.

  • 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.
  • Visit Business Insider’s Investing Reference library for more stories.

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.

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.

Interest 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. 

Capital gains

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.

capital gains

Dividend income

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.

Annuity payments

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

Read the original article on Business Insider

Interest income from your investments is taxable – here’s how to calculate what you owe and ways to lower it

interest income1
Most interest income earned by your savings and investments counts as taxable income. It’s taxed at the same rate as your regular income.

Paying income taxes is a fact of life. And when the IRS says income, it means all the money you make – both earned, from your work, and unearned, from your investments. That includes interest income – money generated by bank or brokerage accounts, and from certain assets, like bonds or mutual funds.

A few exceptions aside, most investment interest is taxable income. You’re required to report it on your return and give the government a cut of it.

 So it helps to know a little more about how interest income impacts your tax bill.

What is interest income?

Most types of interest income are subject to both federal and state taxes. This includes the interest you earn on or from:

Is any interest income tax-free?

Only one major type of asset generates non-taxable interest income: municipal bonds (“munis” for short) and private activity bonds. These are issued by states, counties, cities, and other government agencies to fund major capital projects, such as building public hospitals and schools, highways, power plants, and other civic buildings. 

All munis, along with municipal bond funds, are exempt from federal taxes. If the bond is issued by your home state, the interest income it provides is also free from state and local income taxes. 

Fast fact: Municipal bonds free of federal, state, and local taxes are dubbed “triple-tax-exempt” bonds. 

You also get a bit of a break on US Treasuries and savings bonds. You pay federal income tax on them, but they’re exempt from state and local income taxes. 

What’s the tax rate on interest income?

Interest income doesn’t have a special tax rate the way profits on your investments, aka long-term capital gains, do. You pay taxes on the interest as if it were ordinary income – that is, at the same rate as your other income, such as wages or self-employment earnings. 

So, if you’re in the 24% tax bracket, you’ll also pay a 24% rate on your interest income.

For the 2020 and 2021 tax years, there are seven tax brackets: 

2020 Tax Brackets (tax returns filed in 2021)

Tax Rate Single Head of Household Married Filing Jointly Married Filing Separately
10% Up to $9,875 Up to $14,100 Up to $19,750 Up to $9,875
12% $9,876 – $40,125 $14,101 – $53,700 $19,751 – $80,250 $9,876 – $40,125
22% $40,126 – $85,525 $53,701 – $85,500 $80,251 – $171,050 $40,126 – $85,525
24% $85,526 – $163,300 $85,501 – $163,300 $171,051 – $326,600 $85,526 – $163,300
32% $163,301 – $207,350 $163,301 – $207,350 $326,601 – $414,700 $163,301 – $207,350
35% $207,351 – $518,400 $207,351 – $518,400 $414,701 – $622,050 $207,351 – $311,025
37% $518,401 and up $518,401 and up $622,051 and up $311,026 and up

2021 Tax Brackets (tax returns filed in 2022)

Tax Rate Single Head of Household Married Filing Jointly Married Filing Separately
10% Up to $9,950 Up to $14,200 Up to $19,900 Up to $9,950
12% $9,951 – $40,525 $14,201 – $54,200 $19,901 – $81,050 $9,951 – $40,525
22% $40,526 – $86,375 $54,201 – $86,350 $81,051 – $172,750 $40,526 – $86,375
24% $86,376 – $164,925 $86,351 – $164,900 $172,751 – $329,850 $86,376 – $164,925
32% $164,926 – $209,425 $164,901 – $209,400 $329,851 – $418,850 $164,926 – $209,425
35% $209,426 – $523,600 $209,401 – $523,600 $418,851 – $628,300 $209,426 – $314,150
37% $523,601 and up $523,601 and up $628,301 and up $314,151 and up

Interest income can also be subject to another tax called the Net Investment Income Tax (NIIT). The NIIT is a 3.8% tax on the lesser of:

  • Your net investment income, which is generally all of your investment income (including interest, dividends, capital gains, distributions from annuities, income from passive activities, rents, and royalties) minus investment expenses, or
  • The amount of your modified adjusted gross income that exceeds $200,000 for singles/heads of household, $250,000 for married couples filing jointly, and $125,000 for married couples filing separately.

How do I report interest income on my tax return?

Around January 31 of each year, you should receive Form 1099-INT from any bank, brokerage firm, or other sources of interest income showing the interest your investments earned in the prior year. 

In most cases, it’s easy to take the numbers from Form 1099-INT and transfer them to the appropriate place on your tax preparation software or tax return. The figures to focus on are in boxes 1, 3, and 8.

Boxes 1 and 3 of Form 1099-INT show regular taxable interest income and taxable interest from US Savings Bonds and Treasury Bonds. Box 8 shows tax-exempt interest. 

Where is taxable interest income reported on the tax return?

If you received more than $1,500 of taxable interest or dividends during the year, you report all of that interest and dividend income on Schedule B attached to your Form 1040. If your earnings didn’t reach that threshold, you don’t need to fill out Schedule B. Instead, you just report tax-exempt interest and taxable interest on lines 2a and 2b of your Form 1040.

Your 1099-INT forms should have all the info you need. They may not be complete, though. Banks and brokerage firms are only required to send you a form if they paid you more than $10 in interest during the year. So if you earned $5 in interest from a savings account, it’s still taxable – you just might not get a 1099-INT.

So, it’s a good idea to keep track of it yourself, too – because you’re required to report all interest income on your return, no matter how small. If you have lots of accounts in various places, it could add up.

Is there any way to avoid taxes on interest income?

It’s hard to avoid paying taxes on your interest income, but there are a few strategies to try, especially with assets that generate a lot of income. 

  • Keep assets in tax-exempt accounts, such as a Roth IRA or a Roth 401(k). No matter what the investment, you never owe taxes on anything earned in such accounts, as long as you obey the withdrawal rules. 
  • Keep assets in education-oriented accounts, like 529 plans and Coverdell education savings accounts. All earnings in these accounts are tax-free, as long as they’re used for academic expenses.
  • Invest assets in tax-deferred accounts, such as a traditional IRA or 401(k) to put off paying taxes until you withdraw the money in retirement, and you’re presumably in a lower tax bracket.
  • Invest in municipal bonds issued in your home state to qualify for the triple-tax-exempt treatment. 
  • Invest in US Treasuries to avoid state income taxes, especially useful if you live in a highly taxed locality. 

The financial takeaway

No matter the source, most interest earned by your savings and investments counts as taxable income. It’s taxed at the same rate as ordinary income – based on your regular tax bracket for the year. 

Avoiding interest income tax boils down to seeking out certain exempt assets – mainly municipal bonds and US Treasuries – and using tax-advantaged accounts, in which money earns tax-free or at least tax-deferred. 

The financial institutions holding your accounts send annual statements of your interest income called Form 1099. So keep track of these, and report all of your investment income. The IRS gets copies of all of your 1099s, so they’ll know quickly if you leave anything out. 

Related Coverage in Investing:

Where to invest when interest rates are low – 6 fixed-rate vehicles that offer the best returns

Investment income is money earned by your financial assets or accounts, and understanding how it works can help maximize your profits

How to take advantage of low interest rates – the best financial moves for investors and borrowers

Understanding the way compound interest works is key to building wealth or avoiding crushing debt. Here’s how to make it work for you

Fixed-income investing is a strategy that focuses on low-risk investments paying a reliable return

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