If you are asked which marginal tax bracket you are in, there are usually two answers: one rate for ordinary income and a lower rate for qualified income. Investment income can be either ordinary or qualified. Let’s take a look at how investments are taxed and how they can affect your federal tax liability. Remember that we are discussing federal income taxes and that state income tax policies will vary.
Note that what follows applies to investments in taxable accounts, not to investments held in retirement accounts. Regardless of the types of investments held, Traditional IRAs, 401(k)s, and 403(b)s will be free of taxation until money is withdrawn, when it will be taxed at ordinary income tax rates. Qualified withdrawals from Roth accounts are tax-free.
Interest from bonds and bond funds
Interest from taxable bonds, bond funds and exchange-traded funds (ETFs), and other interest-bearing vehicles, such as CDs and savings accounts, is generally taxed at ordinary income tax rates in the year it is earned. Interest from Treasury bonds is not taxed at the state and local level. Interest from municipal bonds issued by state or local authorities is not taxed by the federal government or by the issuing state, but may be taxable by other states.
Dividends from stocks and mutual funds
This is where things can be a little confusing. Plain vanilla dividends from most individual stocks are usually “qualified” and therefore are taxed at lower, more favorable tax rates by the federal government. This also carries over to mutual fund dividends to the extent that they are generated from common stocks held within the mutual funds. However, there are some stocks dividends that are not qualified and are taxed at ordinary income tax rates. These are usually from companies such as real estate investment trusts (REITs) and master limited partnerships (MLPs), as well as some foreign companies that pay no federal income tax. Dividends from preferred stocks also may be taxed at ordinary rates or qualified rates, depending on the type of issuing company.
When you sell a security at a gain, you will pay a capital gains tax at either your ordinary income tax rate, if you held the security for less than a year, or at the lower, capital gains rate, if you held the security for at least a year. If your 2022 taxable income is less than $83,350 (joint) or $41,675 (single), which closely corresponds to a marginal tax rate of 12% or less, your long term capital gains rate is 0%. That means you can “harvest”, or sell, gains without being taxed, as long as your gains do not raise your taxable income above those thresholds. If your 2022 taxable income is between $83,350 and $517,200 (joint) or between $41,675 and $459,750 (single), your capital gains rate is 15%. Above that they will be taxed at a 20% rate.
You have some control over the timing of your capital gains (and losses) when you own individual securities. This allows you to take gains or losses to minimize your tax liability, if done at the right times. However, you may incur capital gains taxes due to mutual fund distributions, even though you didn’t sell any of your mutual funds. That’s because mutual fund managers must distribute their fund’s capital gains each year.
Actively-managed mutual funds are not tax-efficient, whether they are held in a taxable account or a retirement account. In a taxable account, you are likely to be subject to capital gain taxes each year, while in a retirement account you are not benefiting from the lower tax rates enjoyed by qualified dividends and long term capital gains.
Exchange-traded funds and indexed mutual funds are also required to distribute their capital gains each year. However, due to low turnover in holdings, as well as certain practices ETF managers can use to minimize taxable capital gain distributions, the gains are generally not significant.
Net Investment Income Tax
Your investment income may be subject to an additional tax on your investment income if you have net investment income and your adjusted gross income (AGI) exceeds $250,000 (joint) or $200,000 (single). If that is the case, a 3.8% tax is applied to the lower of two figures: either your net investment income or the amount that your AGI exceeds those income thresholds.
Non-qualified annuities, which are funded with after-tax money, are tax-deferred until withdrawn. If the annuity is “annuitized”, meaning that if periodic withdrawals are set up for a period of time or for life, part of each withdrawal is tax-free and the rest is taxed at ordinary income tax rates. If ad hoc withdrawals are made, they are fully taxed at ordinary rates until the only money remaining in the annuity is your basis, consisting of the original investment and any subsequent after-tax additions.
Qualified annuities, which could be IRAs or other retirement plans, are funded with pre-tax money and are therefore fully taxable at ordinary tax rates when withdrawn.
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The views and information contained in this article and on this website are those of West Branch Capital LLC and are provided for general information. The information herein should not serve as the sole determining factor for making legal, tax, or investment decisions. All information is obtained from sources believed to be reliable, but West Branch Capital LLC does not guarantee its reliability. West Branch Capital LLC is not an attorney, accountant or actuary and does not provide legal, tax, accounting or actuarial advice.