You’ve done your research and you’re feeling pretty good about your investment decisions. But the absolute return is only part of the equation. The next steps are to understand what constitutes income and how different types of income are treated under the federal tax rules, and to determine your tax liability. While the rules change periodically, knowing the fundamentals can help you save on taxes.
Income extends beyond wages, interest, dividends, annuities, royalties and alimony—it’s any form of realized income, including property or services you receive. Debt that is canceled or forgiven (from a mortgage or student loan) is also considered income for tax reporting purposes. If you’re wondering if it’s income, the answer most likely is yes.
That said, your gross income isn’t fully taxable. IRS rules allow the following adjustments:
- Above-the-line adjustments (the “line” here is your adjusted gross income), such as retirement plan contributions, alimony and self-employed health insurance. Note that alimony is deductible but child support is not.
- Special exclusions, such as tax-free municipal bond (muni) income, gifts, inheritances and life insurance proceeds
- Deductions, such as the standard deduction or itemized deductions for such things as qualified mortgage interest, state and local taxes, and charitable gifts
- Personal and dependent exemptions
- Credits, such as foreign tax credit
If you’re subject to the alternative minimum tax (AMT), check with your tax professional to see which deductions are allowed and which are not.
Here are the three main types of income.
- Ordinary: From wages, self-employment income, interest, dividends, etc.
- Capital: From the sale of property.
- Passive: From investments in real estate, limited partnerships or business activities where participation is immaterial.
Each income type has a few subcategories that receive special treatment. For example, municipal bond interest is considered tax-exempt, and “qualified” dividends are taxed at the lower, long-term capital gains rate.
Finally, special rules apply to the interaction between these categories. For example, passive losses can usually offset other passive income, but generally not ordinary income.
Think of our income tax system as a series of steps, where each step (or income bracket) is taxed at a higher rate. Your effective tax rate is the total amount of tax you pay divided by your taxable income (or AGI, in some cases). This average is your actual tax liability, and it’s typically lower than the marginal rate.
But it’s important to know your marginal tax rate for planning purposes because this is the tax you pay on your next dollar of income. If your effective rate is 22% and your marginal rate is 35%, you pay 35 cents on the next dollar of income, not 22 cents. (By the same token, you save 35 cents on the next dollar you donate to charity, not 22 cents.)
Thus, knowing your marginal tax rate can help you decide which assets go best in taxable vs. nontaxable accounts, whether municipal bonds make sense in taxable accounts, or how much bang for the buck you might receive from making a charitable contribution or harvesting capital losses.
The Social Security tax is fairly straightforward: You pay 6.2% tax on wages up to $118,500 in 2015. The Medicare tax, on the other hand, is a bit more complex.
The Medicare tax rate is 1.45% for earned income up to $200,000 for single filers and up to $250,000 for married couples filing jointly. Earned income that exceeds these amounts has a marginal tax rate of 2.35% (1.45% + 0.9%).
Note: Regardless of your filing status, your employer is required to withhold the additional 0.9% tax on wages that exceed $200,000. If you’re married, filing jointly and your total household earned income falls below the $250,000 threshold, you’ll be eligible for a credit when you file.
Long-term capital gains tax: A top rate of 15% applies to qualified dividends and the sale of most appreciated assets held over one year for single filers with taxable income up to $413,200 or $464,850 for married filing jointly. Anything over that threshold is taxed at a top rate of 20%.
Short-term capital gains tax: Appreciated assets held for less than a year receive no special treatment and are taxed at your ordinary income tax rate.
Exceptions: Collectibles and depreciation recapture are taxed at 28% and 25%, respectively.
Health care surtax: A 3.8% health care surtax applies to net investment income for taxpayers with AGI over $200,000 for single filers or $250,000 for married filing jointly.
Capital losses: While capital losses can offset capital gains without limit for federal income tax purposes, only $3,000 of capital losses can be used to offset ordinary income per year ($1,500 for married couples who are filing separately). For both passive and capital losses, carryover rules allow unused losses to be saved for use in future years.
If you have multiple types of accounts, prudent account placement can help you increase your after-tax return. Broadly speaking, investments that tend to lose less of their return to income taxes, like exchange trade funds (ETFs), can be good candidates for taxable accounts. Likewise, investments that tend to lose more of their return to taxes, including real estate investment trusts (REITs), could go in tax-deferred accounts.
Now, where would you place a REIT ETF? Because REITs strive to generate high-dividend yields (which tend to be nonqualified), and you’re required to pay taxes in the year the dividend is paid, a tax-deferred account can be the way to go.
If all of your investment money is in a 401(k) or IRA, worry less about taxes and just focus on asset allocation and investment selection.
Sometimes certain types of income are taxable in one instance but not another. Here are a few examples.
Municipal bond interest income: Interest income from munis is tax-exempt for regular federal income tax purposes. But if you receive Social Security benefits, muni interest income is used to determine the taxability of your benefits. Also, certain muni interest income generated by “private activity” bonds may be tax-free for regular purposes, but could be included when computing the AMT. On the other hand, muni interest income is excluded when computing the 3.8% health care surtax on net investment income.
Treasury interest: Interest income from Treasuries is excluded for state income tax purposes, but included for federal income tax purposes.
Employee stock options: The spread (difference between the exercise price and fair market value) on nonqualified options and restricted stock is treated as ordinary W-2 income when exercised. The spread on incentive stock options (ISOs) is excluded for ordinary tax purposes, but gets added back in for AMT calculations. Capital gains taxes apply to the subsequent sale of stock in any case, but the rules are a bit more complex for ISOs.
- Identify all your various forms of income.
- Determine the tax treatment of each one (for example, will it be taxed as ordinary income, long-term capital gains, other?).
- Know your marginal income tax bracket, including whether or not you’re subject to the 3.8% health care surtax on investment income.
- After you determine your asset allocation and have chosen your investments, put investments that tend to lose less of their return to income taxes in taxable accounts, while placing investments that lose more of their return to taxes in tax-deferred accounts.
- Consult your tax professional before making any significant transaction.