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?
If all of your investments are held in a Traditional IRA or 401(k) plan account, this isn't an issue because you only have to pay and report investment taxes when you withdraw money from these accounts. But if you have bank accounts or taxable investment accounts, you'll have to figure out what these taxes are, and how much you may owe, every year.
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.)
Earnings taxed as ordinary income
Many investments — including savings accounts, certificates of deposit, money market accounts, annuities, bonds, and some preferred stock — can generate income and dividends that are treated as ordinary income for tax purposes.
While some dividends paid to you as a shareholder of certain domestic or foreign corporations may be also be taxed as ordinary income, in most cases these dividends are taxed at the same rates that apply to long-term capital gains.
Capital gains taxes
When you sell a stock, bond or mutual fund, you’ll usually realize a capital gain or capital loss.
You calculate the outcome by subtracting the cost basis (the amount you originally paid for the investment) from the selling price. If you made a profit, it’s a capital gain. If you sold it for less than its cost basis, it’s a capital loss.
The capital gains tax you’ll pay on the profit will depend on how long you owned the investment. Short-term capital gains, which occur when you sell an investment after holding it for less than a year, are generally taxed as ordinary income.
Long-term capital gains, which you receive if you sell an investment after holding it for a year or more, receive more favorable tax treatment. These gains are generally taxed at special capital gains tax rates of 0 percent, 15 percent, and 20 percent, depending on your taxable 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.
A word about taxable income generated by mutual funds
Most stock mutual funds generate dividend income and capital gains. A portion of these earnings are distributed to you as a shareholder and may be subject to taxes even if they’re reinvested in the fund. It doesn’t matter how the fund performed: It could end the year on a negative note and still declare capital gains distributions.
Other kinds of capital gains
Not all capital gains are taxed the same way. For example:
- The capital gains tax for selling antiques and collectibles at a profit is always 28%, regardless of your taxable income.
- If you sell investment property that you depreciated, you’ll pay a flat 25% rate on the profits from your sale.
- If you sell your home, you can actually add the cost of home improvements you’ve made over the years to increase the cost basis. In any case, the first $500,000 of your profit is exempt from federal taxes if you and your spouse file jointly ($250,000 for single filters).
The Net Investment Tax
If your modified adjusted gross income (MAGI) is above a certain amount, you may be subject to the Net Investment Tax. This is a 3.8% surtax on the portion of your MAGI that exceeds $250,000 if you’re filing jointly, $200,000 if you’re single or the head of your household, and $125,000 if you’re married and filing separately.
Using capital losses to reduce your tax liability
If you sold an investment for less than you paid for it, you can use these capital losses to reduce 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.
Calculating your investment taxes
The actual process of figuring out your investment taxes can be extremely complicated. You'll need to report dividend and bond income and capital gains on separate sections of your tax return. For capital gains, 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.
Most do-it-yourself tax software programs can automatically import dividend income and capital gains from your online investment accounts into the appropriate sections of your tax return, so you don’t have to enter this information manually.
However, if your tax situation is more complicated, or you don’t feel confident doing this on your own, it’s better to work with an accountant or tax professional or your financial advisor to make sure you do it right the first time.
Joelle Spear is a financial advisor and Partner located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. She offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. She can be reached at 508.598.1082 or [email protected]
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2020. Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual's personal circumstances.