How investments are taxed

You’ve built a nest egg, watched your investments grow, and now you’re planning to use your savings. But before you start taking distributions – whether it’s for retirement or something else – you should be prepared for what the withdrawals will mean for your taxes.

Generally, there are two manners in which investment income is taxed: ordinary rates and capital gain rates. Here, we will examine the two types of taxation.

Ordinary income

It’s common for investments to produce ordinary income, often in the form of interest or dividends. Savings accounts, certificates of deposits (CDs), money market accounts, annuities, bonds and some preferred stock, for example, typically generate ordinary income. This income is taxed at your ordinary tax rate, just like wages.

Income that is generated in a taxable account is taxed as ordinary income in the year the income is generated. In some cases, you’ll detail your investments and income on a Schedule B of IRS Form 1040.

Income that is generated in a tax-deferred vehicle, such as a 401(k) or traditional IRA, is not taxed in the year the income is generated because the income is not distributed to the account holder; it is accumulated within the tax-deferred account. Money in such accounts is taxed when it is distributed to the owner, at which point it’s taxed as ordinary income.

It’s worth noting that some investment income is not subject to any federal or state tax, depending on the investment and state of issuance. Municipal bonds and US securities are examples of vehicles that generate tax-exempt income.

Capital gains

When you decide it’s time to sell an investment, you’ll realize a capital gain or loss. Special capital gains taxes, which may be lower than ordinary income tax rates, can apply. Before you can calculate your capital gain or loss, or determine how much you’ll owe in taxes from the sale of the asset, you must understand something called basis.

The initial basis is equal to the cost of the asset. For example, if you purchased one share of stock for $300, then your initial basis in the stock is $300. If your asset was a gift or inheritance, or received in a tax-free exchange, your initial basis may differ.

The adjusted basis reflects how the value of your initial investment has increased or decreased over time due to certain circumstances. For example, while a stock dividend paid in cash will be taxed as ordinary income, a dividend paid in additional shares would affect the basis of your original shares, as would a company’s stock split. Real property and business assets are also subject to adjusted basis calculations. Refer to IRS Publication 551 for details about which items increase the basis of your asset and which decrease it.

In the simplest form, your capital gain or loss is equal to the amount you receive for selling the asset minus your adjusted basis.

You’ll report short-term and long-term capital gains and losses on the Schedule D of your income tax return. In addition to the adjusted basis and sale price, you’ll need to know your holding period, your realized gain or loss, and the type of asset involved. See IRS Publication 544 for details.

Holding period: Generally, the holding period refers to how long you owned an asset. If the asset was held for a year or less, gains on it are classified as short-term gains; longer than one year is considered a long-term gain. This is important because tax rates applied to long-term capital gain income are typically lower than those applied to short-term capital gain income. Short-term capital gains are taxed at the same rate as your ordinary income.
Calculations: Long-term capital gains and qualified dividends are generally taxed at special capital gains tax rates of 0%, 15%, and 20% depending on your taxable income. There are some types of capital gains, such as those from precious metals and other collectibles, that could be taxed as high as 28%. The process of calculating tax on long-term capital gains and qualified dividends is dependent on how much taxable income you have for the year your gross income less any deductions that are available to you.
Type of asset: The type of asset you sell will dictate the capital gain rate that applies and even the steps you should take to calculate the capital gain or loss. For example, the sale of an antique is taxed at the maximum tax rate even if you’ve held it for more than a year.

You can use the capital losses from one or more investments to reduce the capital gains from other investments. If you have a net capital loss for the year, you can also use it to offset ordinary income, up to predetermined amounts each year. Losses that you don’t use this year can be used to offset future capital gains. Schedule D of your federal income tax return can guide you through this process.

Understanding the Medicare contribution tax

High-income individuals may be subject to a 3.8% Medicare contribution tax on unearned income. It is important to remember that this tax applies only to net investment income. This tax, which first took effect in 2013, applies to individuals, trusts and estates, and other entities with pass through income. The tax is equal to 3.8% of the lesser of:

Your net investment income from interest, dividends, annuities, royalties, rents, capital gains and other passive business income
The amount of your modified adjusted gross income that exceeds $200,000; or $250,000 if married and filing a joint federal income tax return; or $125,000 if married and filing a separate return

It’s worth noting that distributions from qualified retirement plans and IRAs is not considered net investment income for the purposes of this additional tax. Such distributions can, however, increase your modified adjusted gross income to above the threshold amounts and subject investment income to the Medicare surtax.

CONCLUSION

The taxes for the sale of some assets are more difficult to calculate than others, so you should consult your financial professional before disposing of assets. Consult a tax professional as well, to be sure you’re reporting all income accurately. This will ensure you’re leveraging the most tax-efficient strategy when you’re ready to start taking distributions. You’ve put in the work to grow your investments, so it’s worth the effort to make sure you’re using them in the most effective way.

This material has been created by Raymond James for use by its financial advisors.

While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of Raymond James, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.

Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person's situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation.