What do we mean by investment income?
Let’s start there I suppose. Investment income primarily refers to interest income, dividends, and capital gains. These are the types of taxable income generated by investments in stocks, bonds, money market funds, etc. When we talk taxes on investment income, we are generally not referring to the money that sits in your 401(k) or IRA. Since these accounts are tax-deferred, the income generated within the account is not taxable. If you don’t have any money outside of your retirement accounts, you probably don’t have investment income to worry about and can carry on with the rest of your day.
Interest is paid by banks usually. Banks are big buildings with money and people inside who sometimes cause a financial crisis (only once in a while). When you receive interest income from a savings account, money market fund, CD, or other interest-generating investment, it is almost always taxed as ordinary income. In other words, it gets added to your taxable income and is taxed at your marginal income tax rate. For the most part, it’s taxed the same way that your wages from your job get taxed. This outcome is not as favorable as some of the other investment income discussed below.
If you own shares of a stock, the company that you’re holding will sometimes pay dividends to its shareholders. Dividends are distributions of company profits. There are two types of dividends – ordinary and qualified. Ordinary are dividends are dividends that are paid to you when you have held the stock for less than 60 days prior to the ex-dividend date. When a company announces their quarterly dividend, they announce that you must be a shareholder by a certain date in order to get paid the dividend, which is called the record date. The ex-dividend date is generally one day before the record date. Ordinary dividends are taxed as ordinary income, just like interest income is.
Qualified dividends are for shareholders who have held the stock for at least 60 days prior to the ex-dividend date. In other words, longer-term shareholders will almost always be paid qualified dividends. Qualified dividends are taxed at the more-favorable long-term capital gains tax rate, which is 0%, 15%, or 20% depending on your income level. You can find the 2023 capital gains tax brackets here to figure out what your rate is. These rates will always be equal to or lower than your ordinary income tax rate, so qualified dividends are highly preferred over ordinary dividends.
If you own mutual funds like many investors do, you unfortunately don’t have a ton of control over this. Mutual funds that aren’t constantly trading in and out of positions are more likely to have more qualified dividends. Funds that are changing positions frequently will often not meet that 60 day requirement for dividends, and will therefore have many ordinary or nonqualified dividends. They just report the totals to you at the end of the year, so you’re at the mercy of their decisions. This is why it’s important to pick tax-efficient investments.
Capital gains happen when you sell a security. If I buy Apple stock for $100 and later sell when the value is $150, I have a $50 capital gain. Before we determine the tax implications, we have to figure out if it’s a short-term or long-term capital gain. If I’ve held the stock for less than 1 year, it’s going to be a short-term capital gain, which will be taxed at my ordinary income tax rate (unfavorable).
If I’ve held the security for more than 1 year, it’ll be taxed at the long-term capital gains tax rates of 0%, 15%, or 20%. Essentially you get rewarded for tax purposes when you hold securities for a longer period of time. If you’re holding mutual funds, you again don’t have much control over this. You are at the mercy of what the fund considers to be their “capital gain distributions.” However, capital gain distributions are considered long-term capital gains, so you usually get a favorable outcome from these if you don’t sell the mutual fund.
Net investment income tax
This is an additional tax that’s assessed on investment income if you make too much money. For 2023, the threshold is $250,000 if married and $200,000 if single or head of household. If you are over that threshold, you’ll likely be assessed an additional 3.8% tax on your investment income from any of the above sources. So if you are a high-earner and have a lot of investment income, you’ll likely be looking at a maximum federal tax rate of 23.8% on any long-term capital gains or qualified dividends after factoring in the net investment income tax. If your income is below this threshold, you do not have to pay this tax.
In summary, structuring your investments to generate more income that is taxed at the long-term capital gains rates is important. If you are in a high tax bracket, you could save yourself up to 17% in tax by choosing investments that generate these favorable types of income.