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Taxes on Your Investments: The Basics

You work hard for your money, and pay taxes on it. You manage to save and invest some — and in turn you have to pay even more taxes on your investments.

We not only pay taxes first on our earned income from our job or business, but we also pay taxes on our savings and investments income. You can thank the Internal Revenue Service (IRS).

The IRS wants its piece of all of the income that comes your way. Have you heard the saying “put your money to work”? When we put our money to work through investing — we hope to earn more money — and in some instances, it gets taxed.

Determining Your Investment Taxes

Let’s go over the most commonly taxed investments. Luckily, the IRS sets clear expectations.

Take a look at Form 1040 — the common form people fill out as individual taxpayers.

If you scan the form, you’ll see some of the most common types of investment income — interest, dividends, and capital gains.

Real estate and royalties are other common investments. Although they don’t have a line item on the face of the 1040, they are still taxed. They are reported on Schedule E before making their way to a line item on the 1040.

Individuals can also invest in partnerships, LLCs, and S corporations. 

Taxes on Interest

When I think of interest, I think about savings accounts, money market accounts, certificates of deposit (CD), and bonds.

Some checking accounts also pay interest. A bank, company, or other institution pays you interest for keeping your money with them. A money market and CD may require you to “lock your money up” for a certain amount of time.

Terms vary from days to years. Usually the longer you “lock your money up,” the higher the rate of return — or the more money you earn. You may not be able to access it without penalty. Typically, money markets pay a lower interest rate and require you to tie up your money for a shorter period of time.

These investments are typically regarded as safer, less volatile, and traditionally earn a lower rate of return. Less risk, less reward.

Interest is taxed at ordinary income tax rates — or what most people call your “tax bracket,” which ranges from 12 percent to 35 percent.

A bond is a debt issued by a corporation or government organization that you can purchase. For example, a government or municipality may need to raise $100 million to build a bridge.

As a result, that city may float a bond to raise necessary capital from investors. Income earned by municipal bonds is tax-exempt at the federal level.

Corporate bonds are used to raise money for a public or private company, and it is taxable. As an aside, if you consider investing in bonds you will soon see they are rated by independent agencies with letter grades just like the ones you once received in school with letters, pluses, and minuses.

The different rating agencies use different scales. A weak-rated bond is considered a junk bond, meaning it is much more speculative and risky but pays a higher interest rate. The stronger the company, the stronger the grade. The weaker the company, the weaker the grade.

There is a line item on the 1040 for tax-exempt interest and taxable interest. If you earn interest, you’ll receive a Form 1099-INT from the reporting organization. You’ll use this form to determine the tax on your interest income. Click here to see a 1099-INT.

Taxes on Dividends

Dividends apply to income received from stocks, mutual funds, index funds, and exchange-traded funds (ETFs).

When you own stock, even one share, you are a shareholder or stockholder who owns a piece of a company or companies. Some — but not all — stocks pay dividends. Dividends are typically paid quarterly.

Dividends can be classified as qualified dividends or ordinary dividends. Taxpayers and tax preparers do not decide which dividends are qualified and which ones are ordinary, so you don’t need to worry about what’s what.

Your broker will report both to you at year-end when you receive your Form 1099-DIV. If you look at the 1040, you will see a line item for qualified dividends and ordinary dividends.

Qualified dividends are taxed at the capital gains tax rate, which is lower and more favorable. Ordinary dividends are taxed at ordinary income tax rates. We’ll talk about capital gains and the tax rates below.

As mentioned above, if you are entitled to dividends, they’ll be reported on Form 1099-DIV, which you’ll receive from your broker at year-end. For more on what the IRS has to say about dividends, check out their official bulletin on the topic.

A mutual fund is a group of stocks, bonds, or a combination of stocks and bonds. This group is offered and bundled as one security. Mutual funds can have exposure to both domestic and global companies and markets, depending on which fund you select.

A major benefit of mutual funds is that they offer diversification. Mutual fund holders don’t risk owning a single security — instead the diversification mutual funds offer helps limit big price swings or fluctuations.

Mutual funds may offer less upside than a single stock, but they also have a lower downside. Like stocks, mutual funds pay dividends. Mutual funds may also distribute capital gains. Like stocks, these dividends are classified as qualified or ordinary.

Qualified distributions are taxed at capital gains tax rates. These distributions are taxable and are reported to shareholders on a 1099-DIV from their advisor at the end of the year.

This can be challenging from a tax planning purpose — as such, it’s is a good practice to check in with your broker before the end of the year to see the amount distributed.

An ETF is similar to a mutual fund. It is a group of stocks or bonds packaged as one security. ETFs trade like stocks. Likes some stocks and mutual funds, ETFs can pay dividends.

These dividends are classified as qualified or ordinary. ETFs are more tax friendly than mutual funds because they don’t distribute capital gains.

Taxes on Capital Gains

Buy low, sell high. Buy high, sell higher.

A capital gain is when you buy stock or other property and it appreciates in value. When you sell, it becomes a gain.

It’s important to note that we don’t pay tax until the stock or property is sold or realized. You can be sitting on an unrealized gain — if, for instance, your stock portfolio shows appreciation of $10,000, you do not pay capital gains tax on your $10,000 until you sell, and realize that gain.

We buy stocks and other property as an investment. We want the value to appreciate. Unfortunately, not all investments will appreciate and be “winners.” We will buy “losers.” May the winners outweigh the losers.

Capital gains are classified as short-term or long-term, and this is important to keep in mind. Short-term capital gains are investments held and sold before one year. Long-term capital gains kick in when an investment is held for more than a year.

Short-term capital gains are taxed as ordinary income (12 percent to 35 percent) while long-term capital gains are taxed at the capital gains tax rates, which are lower and more favorable. Capital gains tax rates are zero, 15 percent, and 20 percent, depending on your income and tax bracket..

We’ve discussed capital gains, but what if you have a capital loss? If a capital gain is when you purchase an asset and sell it at a price higher than the purchase price, a capital loss is the opposite: A capital loss is when you buy an asset and sell it below the purchase price.

Capital gains are taxable, and capital losses are deductible. Capital losses are netted against capital gains.

Here’s how it works: Long-term capital gains and losses are netted together. Short-term capital gains and losses are netted together. Then the resulting short-term capital gain or loss is netted with the resulting long-term capital gain or loss.

After the netting of capital gains and losses, if a capital loss results, you can deduct only up to $3,000 in the year against ordinary income. The remaining loss amount above $3,000 is carried forward or over to future years.

Taxes on Real Estate

Real estate investors look for a return through appreciation in the value of the real estate and income.

As we discussed with capital gains, we don’t pay tax until a property is sold at a profit. If it is a gain “on paper,” it’s called an unrealized gain. If the property declines in value, it is an unrealized loss.

We pay tax when the property is sold or realized. These gains are taxed as capital gains as previously discussed.

Other real estate investors may be more interested in collecting monthly rental income. Rental income is taxed in the year it is collected. Unlike unrealized appreciation, rental income is realized and taxed.

Rental income is not taxed on the gross rent received. It is taxed on the net income (income after expenses and deductions). Take a look at Schedule E again. Common expenses include real estate taxes, insurance, cleaning, maintenance, and repairs.

A couple of tax benefits of owning and renting real estate are the deductions for depreciation and mortgage interest.

Depreciation is a non-cash expense, meaning you receive a tax deduction but there is no cash outlay. It’s possible to have a positive cash flow while showing no income or a loss.

Here’s an example of the tax benefits of depreciation: Let’s say you own an apartment that you rent out for $1,000 per month, or $12,000 per year. Real estate taxes, insurance, mortgage interest, cleaning, maintenance, and repairs on the apartment add up to be $750 per month, or $9,000 per year.

At first, it appears you would have a profit of $250 per month or $3,000 per year. Here’s where depreciation kicks in. Residential property is depreciated over a 27.5 year period.

So for our example, let’s assume our property cost $100,000. Depreciation on the property would be about $3,636 ($100,000/27.5 years) per year. So your $3,000 profit is now a $636 loss, from a tax perspective of course. In reality, you still had a positive cash flow of $3,000 per year.

Rental income is considered passive income and is taxed at ordinary income tax rates.

Taxes on Royalties

Royalties are generated from minerals like oil and gas and from intellectual properties such as books and music. Like real estate, royalties are also reported on Schedule E.

Unlike other investments, royalties are considered passive income and are taxed at ordinary income tax rates. If you’ve ever watched Shark Tank, you’re familiar with Kevin O’Leary, aka Mr. Wonderful. Mr. Wonderful is always looking for a royalty deal.

As I mentioned above, royalties are passive income. In most cases, once we make an initial investment, we don’t have to make an additional investment and don’t have to do any additional work.

We can just sit back and collect our money. Once a book is written or song is recorded, there is no more work to be done. When a company buys oil or gas rights, it will pay you to extract the natural resources. You don’t have to do anything else.

Other than municipal bond interest, all of the other investments mentioned are taxable.

One thing to consider with municipal bonds: It may seem advantageous to invest in a tax-exempt investment. That could be true. Municipal bonds often offer a lower rate of return. This could offset the tax benefit. Do your research before investing.

The Bottom Line on Investment Taxes

Investing helps us reach financial freedom, and the earlier you start paying yourself first, the better, even if it’s only $10 per week to start.

It’s wise not to rely on Social Security to cover your retirement living expenses. That’s where investing early with diversification and risk tolerance adjusted for your comfort, is essential. Use time to our advantage, and be patient.

Retirement accounts help, but if you would like to retire earlier, you will need investments outside of these accounts.

Also, if you are a high income earner and max out your retirement account, you may have no other investment options available other than a taxable account. Contributions limits amounts apply and vary for different retirement accounts.

Please note that if you own assets that produce income (interest, dividends, capital gains, etc.), you may need to make estimated tax payments to avoid penalty at year-end.

Nobody wants to pay taxes, but having to pay taxes is not a good reason to avoid investing. Paying taxes on investments is a good problem to have because it means you are making money.

Source: Centsai, Accessed 3/6/23




DISCLOSURE: Investment advisory services are offered through Gretchen Stangier, Inc. DBA Stangier Wealth Management (“Stangier Wealth Management”), an investment advisor registered with the U.S. Securities and Exchange Commission. Stangier Wealth Management only offers investment advisory services where it is appropriately registered or exempt from registration and only after clients have entered into an investment advisory agreement confirming the terms of engagement and have been provided copies of the firm’s ADV Part 2A brochure and Part 3 documents.

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