Barbara O’Neill, Extension Specialist in Financial Resource Management
Rutgers Cooperative Extension
Income Taxes on Investment Profits
A high priority financial goal for many people is to have a comfortable lifestyle in later life. Investing can help. Most people do not become wealthy from their earnings alone but, rather, by investing a portion of their income and letting it grow for several decades. Through a combination of regular investment deposits and compound interest, it is possible to build a large amount of wealth over time.
With investing earnings come income taxes, however. An exception is interest earned on municipal bonds, which are tax-exempt at the federal, and perhaps state and local, level. Roth IRA earnings are also not taxed if certain conditions are met. When an investor sells securities- even municipal bonds- and earns a profit, capital gains are realized and income tax is due. A capital gain is defined as the increase in value of a capital asset such as real estate or investments (e.g., stocks and mutual funds). In other words, people realize capital gains when they “buy low” (e.g., stock purchased for $10 a share) and “sell high” (e.g., stock sold for $20 a share).
When investors sell a capital asset, the difference between its basis (generally the amount paid for it) and its sale price is a capital gain or loss. Capital gains may be short- or long-term. A short-term capital gain is a gain made on capital assets that are held for a year or less and a long-term gain is a gain on assets held more than one year. Both types of capital gains must be claimed on tax returns that determine an investor’s income tax payment.
It is often wise for investors, especially those with significant assets, to monitor their tax withholding status. If additional withholding is needed to cover the taxes due on investment gains, investors have two possible strategies. One is to set aside a portion of their investment profit and use it to pay quarterly estimated taxes to the IRS. The other is to have more tax withholding taken out of their paychecks with which to pay taxes.
Short-term capital gains are taxed as “ordinary income” (i.e., income other than long-term capital gains, such as salaries) based on an investor’s marginal tax rate which is determined by tax filing status (e.g., single, married filing jointly, etc.) and household taxable income. Long-term capital gains are taxed at a lower capital gains tax rate which is determined by an investor’s marginal tax rate. Long-term capital gains tax rates range from 0% to 20%, depending on an investor’s financial status.
Taxpayers in the 10% and 15% federal marginal tax brackets pay a 0% long-term capital gains (LTCG) tax rate and most taxpayers qualify for the 15% LTCG rate, which covers taxpayers in the wide swath of the 25%, 28%, 33%, and 35% tax brackets. The highest LTCG tax rate is 20%, which is paid by high-earning investors in the highest (39.6% rate) federal income tax bracket. State income tax rates on investment profits vary among states.
Mutual fund investors can also earn taxable capital gains when the funds that they invest in sell securities and realize a profit. In other words, the gain is realized by a mutual fund itself rather than by individual investors who sell securities profitably. In this situation, investors receive a 1099-DIV form from the fund that lists the amount of the capital gain distribution and the amounts that are classified as short-term and long-term.
If capital losses exceed capital gains, the excess can be deducted on a tax return, and used to reduce other income up to an annual limit of $3,000. If the total net capital loss is more than the yearly limit on capital loss deductions, the unused part can be carried over to the next year. Capital gains and losses are reported on IRS Schedule D and transferred to Line 13 of Form 1040.
Another source of taxable income to investors is dividends. Dividends are a distribution of a portion of a company’s earnings to its shareholders. Dividends are declared by a company’s board of directors and can be made to investors in the form of cash payments or shares of stock. In the case of mutual funds, dividends received by mutual funds from the securities in their portfolio are passed on to fund shareholders.
There are two types of dividends: ordinary (the most common) and qualified. Ordinary dividends are taxed as ordinary income and qualified dividends are generally taxed at LTCG rates (see above description). An exception is dividends received from money market mutual funds. This income is treated as ordinary income. Investors receive a Form 1099-DIV that describes the type and amount of their taxable dividend earnings. Dividends must be reported on tax Schedule B if they exceed $1,500.
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