Taxation of Investment Income

InvestmentNot all investment income is taxed the same. Thanks to the IRS, the tax code regarding your investments is constantly changing, and keeping up with these changes is important to optimize the tax efficiency of your portfolio. Remember, it’s not what you make but what you keep that counts.

The main determinants of investment income tax rates are your annual income, and the type of investment income earned; interest income, dividend, and capital gains. Investments such as savings accounts, certificates of deposit, money markets, annuities, and taxable bonds (as opposed to municipal bonds or US securities), produce interest income. This income is considered ordinary income, and is taxed at an individual’s ordinary income tax rate, which ranges from 0% to 39.6%.

Dividend income can either be taxed at ordinary income tax rates or the preferred capital gains tax rates. Dividends received from domestic corporations and qualified foreign corporations will generally be taxed at the long-term capital gains rate, ranging from 0% to 20%. Dividends received that are not classified as “qualified” dividends will be taxed at ordinary income tax rates.

Capital gains are taxed as either ordinary income or capital gain income depending on how long an investment is held. Investments that are held over one year (long-term capital gain) will be taxed at the preferential capital gains rate, while investments held for less than one year (short-term capital gain) will be taxed at ordinary income tax rates. A capital gain is realized when an investment is sold for a higher amount than the original purchase price, or adjusted cost basis. For tax purposes, it is only the net off all realized capital gains for the year that are taxable. Selling a security for a loss produces a capital loss which can be used to offset other capital gains. If the realized capital losses exceed your capital gains, the IRS allows taxpayers to deduct up to $3,000 of capital losses against ordinary income, while carrying forward any unused realized loss to use in future years.

Finally, in addition to income rates being determined based on type, ordinary vs. capital gain, a taxpayer’s income will affect the amount of tax owed. The chart below highlights the tax rates based on income.

2016 Federal Income Tax Brackets

Tax rate on ordinary income & short term capital gain Single Married Filing Jointly / Qualifying Widow(er) Tax rate of qualified dividends and long term capital gains
10% $0 – $9,275 $0 – $18,550 0%
15% $9,276 – $37,650 $18,551 – $75,300 0%
25% $37,651 – $91,150 $75,301 – $151,900 15%
28% $91,151 – $190,150 $151,901 – $231,450 15%
33% $190,151 – $413,350 $231,451 – $413,350 15%
35% $413,351 – $415,050 $413,351 – 464,950 15%
39.6% $415,051 – $466,951 – 20%

* An additional 3.8% surtax applies to net investment income for taxpayers with AGI over $200,000 (single) and $250,000 (married filing jointly)

As you can see, the tax rates on qualified dividends and capital gains are lower than the tax rates on ordinary income. By strategically placing ordinary income producing assets inside of tax sheltered accounts, and qualified income and capital gains producing assets in taxable accounts, taxpayers can lower the amount of tax on their investment income, without altering their asset allocation. In an effort to maximize the amount that you get to keep on the money that you have earned, having your investment advisor and tax planner working together can be a valuable resource.

Tom Reynolds, CPA & Matt Reynolds CPA, CFP®
(Co-Managing Partners, CRA Financial)
Francis C. Thomas CPA, PFS (Investment Advisor)
Robert T. Martin, CFA, CFP® (Investment Advisor)