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Investment income is any money received from an investment, including interest payments, dividends, capital gains and other profits.
According to the Domestic Tax Authorities (IRS) investment income includes interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in the trading of financial instruments or commodities and businesses that are considered passive activities, such as a limited partner interest in a company.
“Investment income is an important source of income for many Americans, especially retirees who need cash flow to support themselves when they are no longer working,” said James Royal, chief investment writer at Bankrate. “Additionally, investment income can often be taxed at more favorable rates than employment income, making this essential to understand for those looking to build wealth.”
We’ll explore some examples and outline the key tax implications you’ll want to consider.
Examples of investment income
Investment income is often found in investment accounts and interest-bearing savings accounts. Although retirement accounts such as IRAs and 401(k)s can provide investment income, this income is not taxed when paid out. Instead, you will be taxed on the money withdrawn from the account during your retirement. This income is reported on a separate part of your tax return.
Some of the most popular investment vehicles that generate investment income include:
- Shares
- Bonds
- Investment funds, such as mutual funds or ETFs and other securities
- Certificates of Deposit (CDs)
- Property
- Annuities
- The investment part of life insurance contracts
- Interests in trusts and estates
- Collectibles
- Commercial crops
- Bills or other funds to be received and companies
How is investment income taxed?
Your investments that simply increase in value are not considered taxable income unless you sell them and receive a profit. Once you realize a gain on an asset, the IRS considers that investment income.
How investment income is taxed depends on a number of factors, including the holding period, your total income and the type of investment income received. Note: Withdrawals from a traditional 401(k) or traditional IRA are taxed as ordinary income, not capital gains. Withdrawals may be subject to penalties if you are under 59 1/2 years old.
Net Investment Income Tax (NIIT)
Certain investment income may be subject to the Net Investment Income Tax (NIIT). This additional tax applies to individuals with adjusted gross income (MAGI) above certain income thresholds ($250,000 for married couples filing jointly, $200,000 for single filers) and to certain estates and trusts. Taxpayers may owe the NIIT if their MAGI exceeds the legal threshold for their filing status. The NIIT amount is 3.8 percent of the lesser of the net investment income (NII) or the excess of the MAGI above the threshold amount. Wages, self-employment income, Social Security benefits, and benefits from some qualified retirement plans are not subject to the NIIT. You can learn more about the NIIT on the IRS website.
Investment income that may be subject to the NIIT includes:
- Interest
- Dividends
- Added values
- Rental and royalty income
- Nonqualified annuities
- Income from companies involved in the trading of financial instruments
- Commodities and companies that are passive activities for the taxpayer
Capital gains and qualified dividends
Most types of investment income are taxed at normal income tax rates. For example, when you sell an asset you have owned for less than a year for profit, it is considered a short-term capital gain and is taxed at your regular income tax rate, which can range from 10 percent to 37 percent.
However, capital gains from the sale of assets held for more than one year are generally taxed at lower long-term capital gains tax rates, which range from 0 percent to 20 percent. Qualified dividends, which qualify for the same favorable tax rates as long-term capital gains, are typically paid by companies on their common stock.
Interest and ordinary dividends
Interest income may be exempt from federal taxes if generated by municipal bonds, but is not exempt from other potential taxes, such as the NIIT. Interest income is generally taxed at ordinary income rates. Ordinary dividends, unlike qualified dividends, may also be taxed at regular income tax rates. Ordinary dividends are usually paid by real estate investment trusts (REITs) and master limited partnerships (MLPs).
Rental income and home sales
Rental income is considered investment income and is taxed accordingly. In certain cases, it may be considered business income and therefore qualify for qualified income tax treatment. It’s best to check this with the tax authorities and your accountant, just to be sure.
If you sell your primary residence (your home), the IRS may exempt the first $250,000 ($500,000 in the case of a married couple) of gain recognized on the sale from gross income for regular income tax purposes. This amount would therefore be exempted from the NIIT. To qualify for the exemption, you must have used the home as your principal residence for a cumulative, but not necessarily consecutive, two years of the last five years prior to the sale.
What is income investing?
Changing the word order makes a difference here: investing in income is not the same as investing in income.
Income investing is the practice of building a portfolio of assets that generate cash on a recurring basis. Income investors want to maximize the amount of cash they receive and therefore usually choose to invest in assets that pay dividends, interest or rent on a regular basis. These types of investments form the stable basis of a portfolio.
Common stock dividends are generally lower than preferred stock dividends, but common stock offers the prospect of unlimited capital gains. However, common shares are riskier because their price can fluctuate more than preferred shares, and often result in a total loss in the event of bankruptcy because they are last on the list of claim holders.
Some common examples of income investment assets include:
- Dividend paying stocks
- Bonds
- Property
- Money Market funds
- Certificates of deposits
- Money Market Accounts
- Annuities
In short
Investment income is the money you earn from your investments, including regular accounts such as interest-bearing savings accounts and investment accounts. While investment income is a great way to build wealth, keep in mind that some investments can complicate your taxes. If you find yourself lost during tax season, consult a tax professional. In fact, you may want to consider hiring a financial planner before investing.
