It’s nice to own stocks, bonds, and other investments. Nice, that is, until it’s time to fill
out your federal income tax return. At that point, you may be left scratching your head. Just how do you report your investments and how are they taxed?
Is it ordinary income or a capital gain?
To determine how an investment vehicle is taxed in a given year, first ask yourself what
went on with the investment that year. Did it generate interest income? If so, the income
is probably considered ordinary. Did you sell the investment? If so, a capital gain or loss
is probably involved. (Certain investments can generate both ordinary income and
capital gain income, but we won’t get into that here.)
If you receive dividend income, it may be taxed either at ordinary income tax rates or at
the rates that apply to long-term capital gain income. Dividends paid to an individual
shareholder from a domestic corporation or qualified foreign corporation are generally
taxed at the same rates that apply to long-term capital gains. Long-term capital gains
and qualified dividends are generally taxed at special capital gains tax rates of 0
percent, 15 percent, and 20 percent depending on your taxable income. (Some types of
capital gains may be taxed as high as 25 percent or 28 percent.) The actual process of
calculating tax on long-term capital gains and qualified dividends is extremely
complicated and depends on the amount of your net capital gains and qualified
dividends and your taxable income. But special rules and exclusions apply, and some
dividends (such as those from money market mutual funds) continue to be treated as
ordinary income.
The distinction between ordinary income and capital gain income is important because
different tax rates may apply and different reporting procedures may be involved. Here
are some of the things you need to know.
Categorizing your ordinary income
Investments often produce ordinary income. Examples of ordinary income include
interest and rent. Many investments — including savings accounts, certificates of
deposit, money market accounts, annuities, bonds, and some preferred stock — can
generate ordinary income. Ordinary income is taxed at ordinary (as opposed to capital
gains) tax rates.
But not all ordinary income is taxable — and even if it is taxable, it may not be taxed
immediately. If you receive ordinary income, the income can be categorized as taxable,
tax exempt, or tax deferred.
- Taxable income: This is income that’s not tax exempt or tax deferred. If you
receive ordinary taxable income from your investments, you’ll report it on your
federal income tax return. In some cases, you may have to detail your
investments and income on Schedule B. - Tax-exempt income: This is income that’s free from federal and/or state
income tax, depending on the type of investment vehicle and the state of
issue. Municipal bonds and U.S. securities are typical examples of
investments that can generate tax-exempt income. - Tax-deferred income: This is income whose taxation is postponed until some
point in the future. For example, with a 401(k) retirement plan, earnings are
reinvested and taxed only when you take money out of the plan. The income
earned in the 401(k) plan is tax deferred.
A quick word about ordinary losses: It’s possible for an investment to generate an
ordinary loss, rather than ordinary income. In general, ordinary losses reduce ordinary
income.
Understanding what basis means
Let’s move on to what happens when you sell an investment vehicle. Before getting into
capital gains and losses, though, you need to understand an important term — basis.
Generally speaking, basis refers to the amount of your investment in an asset. To
calculate the capital gain or loss when you sell or exchange an asset, you must know
how to determine both your initial basis and adjusted basis in the asset.
First, initial basis. Usually, your initial basis equals your cost — what you paid for the
asset. For example, if you purchased one share of stock for $10,000, your initial basis in
the stock is $10,000. However, your initial basis can differ from the cost if you did not
purchase an asset but rather received it as a gift or inheritance, or in a tax-free
exchange.
Next, adjusted basis. Your initial basis in an asset can increase or decrease over time in
certain circumstances. For example, if you buy a house for $100,000, your initial basis
in the house will be $100,000. If you later improve your home by installing a $5,000
deck, your adjusted basis in the house may be $105,000. You should be aware of which
items increase the basis of your asset, and which items decrease the basis of your
asset. See IRS Publication 551 for details.
Calculating your capital gain or loss
If you sell stocks, bonds, or other capital assets, you’ll end up with a capital gain or loss.
Special capital gains tax rates may apply. These rates may be lower than ordinary
income tax rates.
Basically, capital gain (or loss) equals the amount that you realize on the sale of your
asset (i.e., the amount of cash and/or the value of any property you receive) less your
adjusted basis in the asset. If you sell an asset for more than your adjusted basis in the
asset, you’ll have a capital gain. For example, assume you had an adjusted basis in
stock of $10,000. If you sell the stock for $15,000, your capital gain will be $5,000. If you
sell an asset for less than your adjusted basis in the asset, you’ll have a capital loss. For
example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for
$8,000, your capital loss will be $2,000.
Schedule D of your income tax return is where you’ll calculate your short-term and long-
term capital gains and losses, and figure the tax due, if any. You’ll need to know not only your adjusted basis and the amount realized from each sale, but also your holding
period, your taxable income, and the type of asset(s) involved. See IRS Publication 544
for details.
- Holding period: Generally, the holding period refers to how long you owned
an asset. A capital gain is classified as short term if the asset was held for a
year or less, and long term if the asset was held for more than one year. The
tax rates applied to long-term capital gain income are generally lower than
those applied to short-term capital gain income. Short-term capital gains are
taxed at the same rate as your ordinary income. - Taxable income: 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. (Some types of capital gains may be
taxed as high as 25 percent or 28 percent.) The actual process of calculating
tax on long-term capital gains and qualified dividends is extremely
complicated and depends on the amount of your net capital gains and
qualified dividends and your taxable income. - Type of asset: The type of asset that you sell will dictate the capital gain rate
that applies, and possibly the steps that you should take to calculate the
capital gain (or loss). For instance, the sale of an antique is taxed at the
maximum tax rate of 28 percent even if you held the antique for more than 12
months.
Using capital losses to reduce your tax liability
You can use capital losses from one investment to reduce the capital gains from other
investments. You can also use a capital loss against up to $3,000 of ordinary income
this year ($1,500 for married persons filing separately). Losses not used this year can
offset future capital gains. Schedule D of your federal income tax return can lead you
through this process.
New Medicare contribution tax on unearned income may apply
High-income individuals may be subject to a 3.8 percent Medicare contribution tax on
unearned income (the tax, which first took effect in 2013, is also imposed on estates
and trusts, although slightly different rules apply). The tax is equal to 3.8 percent of the
lesser of:
- Your net investment income (generally, net income from interest, dividends,
annuities, royalties and rents, and capital gains, as well as income from a
business that is considered a passive activity), or - The amount of your modified adjusted gross income that exceeds $200,000
($250,000 if married filing a joint federal income tax return, $125,000 if
married filing a separate return)
So, effectively, you’re subject to the additional 3.8 percent tax only if your adjusted
gross income exceeds the dollar thresholds listed above. It’s worth noting that interest
on tax-exempt bonds is not considered net investment income for purposes of the
additional tax. Qualified retirement plan and IRA distributions are also not considered
investment income.
Getting help when things get too complicated
The sales of some assets are more difficult to calculate and report than others, so you
may need to consult an IRS publication or other tax references to properly calculate
your capital gain or loss. Also, remember that you can always seek the assistance of an
accountant or other tax professional.
Note: This listing is comprehensive and includes a portion of what you noted in the submission): The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and its advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Neither IFP Advisors LLC, IFP Securities LLC, dba Independent Financial Partners (IFP), nor their affiliates offer tax or legal advice. Any potential tax advantages or benefits will depend on your circumstances. Consult your tax professional and/or legal expert about your individual tax situation and visit IRS.gov to learn more.