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Home > Politics, Taxes > Basics of Investment Taxes

Basics of Investment Taxes

When you invest money in regular taxable accounts (not your 529 college savings accounts, IRAs, 401Ks, or other retirement investment accounts), any money your earn is typically added to your total yearly income for income tax calculation purposes. In this article, I will discuss (3) common types of investments and what taxes will be due.

First, the Good News

No one likes paying taxes, but you are probably not shocked to find out that investors pay less taxes than workers earning income, or sometimes even savers. There are a number of reasons why this is the case.

1.      Public insurance programs (unemployment insurance, Social Security, disability programs, etc) are typically funded from deductions taken from worker salaries. These programs are designed to tie directly to employment. Investing income does not apply, so taxes do not apply.

2.      Legislators have over time given preferential treatment to ‘capital’ since this is the source of job creation.

3.      Investors sometimes pay taxes on investment income in addition to the corporate taxes already paid by the company. The lower investment tax rates try to lessen this double tax impact.

Earning income through investing can therefore off the opportunity to increase your take home pay more than working more hours, because you get to keep more of what you earn.

Next, Capital Versus Investment Income

To understand taxes, you first need to know the difference between capital versus investment income. Capital is the stake that you have in the investment, which is the value of the shares of the company or the total bond value. Capital has historically had the most favorable tax treatment, while investment income has less favorable treatment.

Let’s say you bought $10,000 worth of Johnson and Johnson (JNJ), and you earned $300 in dividends during the year. The total value of your capital is $10,000 (at the time you purchased the shares), and the value of your investment income is $300.

Capital Gains Taxes

Capital gains taxes come into play when you sell your investment. Using the example above, if we sell the JNJ shares for $12,000, a capital gain is realized. If the gain occurred on a short term basis (less than one year), you pay the same rate as your income tax rate. For a long term gain (greater than one year), the lower capital gain rate applies.

On to the investment types. This concerns (3) different types of investment income.

Fully Taxable Income

With a fully taxable investment, you pay your marginal income tax rate. This is the highest rate you will pay, it is the same income tax rate as if you earned additional money by working additional hours. You still pay less taxes because you do not pay any payroll taxes that would be due with work income, you pay just the income taxes.

There are many reasons why an investment would be fully taxable, here are a few:

  • The company itself is not required to pay any taxes due to its registration/structure. The most common examples are real estate investment trusts (REITs). The tax burden is passed on to the investor.
  • The company does not pay enough corporate taxes for investors to qualify for lower investment tax rates.
  • The investment is a bond or bond-like, these generally do not get the lower rates.

Non Taxable Investment Income

Some investments are not taxable at all. The most common examples are municipal bonds, which are issued by local/state governments typically to fund capital projects. If you otherwise have lots of other income, these can lower the amount of taxes you pay because the U.S. Federal Government also exempts these from taxation in addition to the local/state government that issued them.

Note that U.S Treasury bonds/notes are not the same as municipal bonds, they are used to fund the general operations of the federal government. They are fully taxable at the federal level at marginal income tax rates.

Qualified Investment Income

Most common stocks fall into the category of qualified investments (JNJ mentioned above is an example). Holders of qualified investments pay federal income taxes at a lower rate than their working income tax rates. The word ‘qualified’ has a specific meaning, in that the company must follow some rules that show that the company paid enough corporate taxes. Then, the investor gets the lower tax rate.