Investment tax must be paid on interest income and rent from investment property. You also pay investment tax on dividend and capital gains income from stocks, mutual funds and exchange-traded funds. Holding stocks and bonds in taxable accounts allows for a larger tax liability than if you hold the securities inside a retirement account with tax-deferred provisions. You may want to work with a financial advisor to determine the best mix of taxable and retirement accounts for your needs.
Investment Tax on Interest Income
Interest income is usually taxed as ordinary income. You pay investment tax on it at your marginal tax rate which is the tax rate on the last one dollar of your income. Most people are familiar with the interest income they earn on investments such as bank savings accounts and certificates of deposit. There are other interest-earning investment assets that are taxable. If you have a brokerage account, investment tax must also be paid on the interest income you earn on the cash in your account.
You may own fixed income investments. The most common fixed income investment are bonds. Bonds issued by a corporation are subject to investment tax on earned interest income. State and local governments issue municipal bonds. The interest income from municipal bonds is not subject to federal tax. In some states, it may be subject to state and local tax.
Another type of fixed income investment is in federal government bonds including Treasury securities. Interest income paid by federal government bonds is not taxed at the state or local level.
If you own an individual retirement account (IRA) or a 401(k), you may have fixed income securities as investments in those accounts. The securities are tax-deferred while they are invested. When you start making withdrawals after age 59 1/2, you pay investment tax on the withdrawals. If you own a Roth IRA, you never pay investment tax on a withdrawal as long as you are at least 59.5.
Investment Tax on Rental Income
Owning investment property from which you collect rent will make you subject to investment tax on the rent. Rental income is taxable at your ordinary tax rate. The good news is that rent is considered a passive source of income rather than income you earn actively working for wages from a job. One difference between passive income and earned income is that you don’t pay the 6.2% Social Security tax or the 1.42% Medicare tax on passive income. Along with federal tax, you do usually pay state and local tax on passive income. It’s important to note that you can only deduct passive losses to the extent they cancel out passive gains.
If you have rental property, chances are you won’t have to pay investment tax on all your income. You can deduct operating expenses from the rental income you receive. One operating expense is mortgage interest, if you owe a mortgage on the property. Other examples of operating expenses are maintenance expenses, property tax and liability insurance. Operating expenses are deductible dollar for dollar.
Depreciation is a valuable deduction when you own rental property. Depreciation allows you a tax deduction for the yearly costs of obsolescence of the structure and equipment but not for the cost of the land. You usually can’t deduct the total cost of your investment in one year. Instead, you spread the depreciation deduction out over 27.5 years. This allows you to further reduce your taxable rental income.
The Tax Cut and Jobs Act of 2017 allowed for a qualified business income deduction (QBI) in most cases of rental property. The QBI provides another significant tax deduction from your taxable rental income.
Investment tax on the rental income you receive is only one part of the tax story for investment rental property. There is also investment tax if you sell your rental property for a profit. Selling for a profit within one year of purchase will subject you to the short-term capital gains tax. You pay taxes at your ordinary tax rate.
If you sell for a profit after more than one year has passed, you will pay taxes at the lower long-term capital gains rate which is either 0%, 15%, or 20% depending on your income and your tax filing status. SmartAsset’s capital gains calculator can help you estimate the amount of capital gains tax you might pay when selling rental property for a profit. The tax rate on capital gains may change in 2021.
Investment Tax on Stocks
If you own stocks in a taxable account, you may receive two types of income from them. The stocks may pay dividends to you. When you sell your stock at a profit, you will also earn capital gains.
Dividend income is taxable at your ordinary income tax rate unless they are qualified dividends. There are three conditions which determine whether a stock issues qualified dividends:
- Qualified dividends occur when you have held the stock for at least 61 days in the 121- day time period that starts 60 days before the stock’s ex-dividend date.
- The stock has to be issued by a U.S. corporation or a foreign corporation that is either listed on a stock exchange or has a tax treaty with the U.S. government.
- The stock is not in certain excluded categories.
If the stock pays qualified dividends, then you are taxed at the lower tax rates of 0%, 15% and 20% depending on your income and tax filing status.
You will also earn capital gains from stock if you sell them at a profit. If you purchase a stock and hold it for less than one year before selling, you will owe investment tax at your ordinary income rate.
If you sell the stock after holding it for more than a year, you will be taxed at the lower, more favorable long-term capital gains rate. The long-term capital gains rate is 0%, 15% and 20% depending on your income and your tax filing status.
Holding stocks inside an individual retirement account (IRA) or a 401(k) is usually a more tax-efficient strategy that holding them in a taxable account.
Investment Tax on Mutual Funds and Exchange-Traded Funds
Mutual funds are baskets of securities chosen for you by professional management. You will owe investment tax on mutual fund income if the fund manager distributes dividends or capital gains during the tax year. Just as with stocks, dividends are taxed at your ordinary income rate. Capital gains are taxed at the more favorable rates.
If you sell shares in the mutual fund, you will pay capital gains tax if you make a profit.
Exchange-traded funds (ETFs) have features of both stocks and market index funds. Market index funds closely track the performance of one of the market indices. However, exchange-traded funds can be traded on the market like stock. Since ETFs are passively managed, they don’t make as many capital gains distributions to investors and may result in lower taxes than mutual funds.
The Bottom Line
Investment tax must be paid on interest income and the income you receive from rental property. You also pay investment taxes on any dividends and capital gains you receive from stocks, mutual funds and exchange-traded funds. You want to maximize the tax-efficiency of your portfolio by putting together the right mix of taxable and tax-deferred securities. This will allow for your need of both current and retirement income.
Tips on Taxes
- A financial advisor can help you strike the most tax-efficient allocation of investable assets. Finding one doesn’t have to be hard. SmartAsset’s matching tool can connect you in just a few minutes with several local advisors. If you’re ready, get started now.
- Capital gains taxes apply to investment income after an investment is sold and a capital gain is realized. Because so many Americans don’t invest at all, they don’t pay capital gains taxes. There are also taxes on dividends and interests stemming from simple interest from a bank account or dividends and earnings from investments. Use this federal capital gains tax calculator to get a good idea of what you owe.
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