Thanks to our tax system, most people remember receiving their first paycheck and experiencing the shock that the amount is different than expected. Then, after learning about the taxes, they get over it and accept that taxes affect just about all our income. But what about taxes on the investments made now for future income in retirement?
Types of Income Taxes
First, let's talk about the two types of taxes we have on income. The first is ordinary income and is the type that applies to our paychecks. It’s a tiered system. The first amount of tax we pay on our income is zero. This is our standard deduction, which in 2022 is $12,950 for single filers, $19,400 for heads of household, and $25,900 for married filers. (For some people, this number is higher if they itemize deductions). The next bit of income is taxed at 10%, then 12%, then 24%, and so on. Currently, our federal tax rate tops out at 37%.
The second kind of federal income tax is capital gains tax. It comes into play when certain investments earn income. This tax is less than ordinary income. Capital gains tax can be 0%, 15% or 20%, depending on your income. Suppose you are fortunate enough to have a high enough income to pay 20% capital gains tax. In that case, you are likely also paying an additional Net Investment Income Tax of 3.8%. But we will save that tax for another day.
The income we earn from stocks and investments can be taxed as ordinary income or capital gains. Let’s dive in.
Ordinary Income Tax:
Most interest is taxed as ordinary income. Typical interest is from deposit accounts such as checking and savings, certificates of deposits, government bonds, and insurance.
- Retirement Account Distributions
When you contribute to a retirement account such as a traditional 401k or 403b, you are not taxed on those funds as they go into the account. But you are taxed when you withdraw from those accounts. The tax will be ordinary income. If you contribute to an Individual Retirement Account, you might receive a tax deduction for the contributions (depending on your income and other factors) and will pay ordinary income tax on the withdrawals. Note: if you contribute to a Roth 410k or Roth IRA, you are using post-tax dollars for the contribution and if you follow the rules you will not be taxed on the withdrawals. Read more about Roth Conversions.
- Non-Qualified Annuities
Non-qualified means the investment is not a retirement account and is simply a regular individual, joint, or trust account. Non-qualified investment contributions are made with after-tax dollars as opposed to pre-tax dollars. To set up an annuity, a person contributes a certain amount of money. When withdrawals are made they will be taxed as ordinary income. However, withdrawals won't be taxed once the account value reaches the cost basis or the original contribution.
- Investments Held for Less Than a Year
If a person invests in securities outside of a retirement account, they are likely investing in a brokerage account. These accounts can be individual, joint, or trust accounts. The income might be treated at the lower capital gains tax with these accounts. But a big caveat is that the investment needs to be held for more than one year. Otherwise, any gain from the sale of the investment will be taxed as ordinary income, and a person will pay more in tax than if they held onto the investment for more than 365 days. This is true no matter what the investment is. It could be an investment in stocks, bonds, mutual funds, art, gold, crypto, and even a house owned for less than a year.
- Ordinary Dividends
Dividends are the portion of a company's earnings that are not reinvested in the company but paid out to investors. Some of the ordinary dividends in brokerage accounts are taxed as ordinary income. To distinguish it from Qualified dividends, you will see this income on your 1099-DIV in box 1.
Capital Gains Tax
- Investments Held Longer Than One Year
In a brokerage account, if the investment is held longer than one year, the gain on that investment will be treated as capital gains. This is true of all the types of investments listed above. There are two exceptions:
Art: Sales of art and collectibles are taxed at a higher capital gains tax of 28%.
House: If you sell your primary residence and have lived in the home for two of the last five years, some gain will be excluded from capital gains tax. The exclusion amount is currently $250,000 for single filers and $500,000 for married filing jointly. If you sell an investment home, this exclusion does not apply, but you might be able to delay capital gains by doing a 1031 exchange, also referred to as a "like-kind exchange."
- Qualified Dividends
Qualified dividends, as opposed to ordinary dividends, are taxed at the capital gain rate. These are dividends from shares in a domestic corporation and certain qualified corporations you have held for a specific minimum period. On a 1099-DIV, you will find these dividends on line 1b or column 1b.
A note about state taxes: When you incur income from investments, you may pay state tax and federal tax. If your state does not have an income tax, you may not pay tax on investment income. Some states, such as Washington, do have a capital gains tax. Other states, such as Minnesota, apply ordinary income to all income, including investment income even if it otherwise qualifies for Federal capital gains tax.
We can’t escape taxes, but we can structure investments, so we pay as little tax as possible. Knowing when you will pay ordinary income tax and when you will pay capital gains tax can help you decide what type of investment to buy and when to sell.