How Your Investment Income Is Taxed
A quick rundown of how the income produced by different investment types is treated at tax time.
Note: This article is part of Morningstar's November 2015 Income Investing Week special report.
Question: Help! I have a hard time keeping track of the ways different income-producing investments are taxed.
Answer: While this is by no means an exhaustive list, it covers some of the main categories of income-producing investments, and how the income they produce is generally treated by the IRS at tax time.
Please note, though, that because every investor's tax situation is unique, you should consult your accountant for verification of your tax status and tax treatment of any investment product mentioned below.
Also, we won't go into capital gains taxes in this article because the tax treatment of them is largely the same regardless of asset class. For more on how capital gains are taxed, see this article.
Stocks With Qualified Dividends
For most stocks that pay qualified dividends, the tax treatment is pretty straightforward: Investors would report the income on a 1099-DIV in the Qualified Dividends box. Investors in the 10% and 15% brackets will have a zero tax rate on dividends. For individuals in income tax brackets greater than 15% but less than 39.6%, qualified dividends are taxed at 15%. Individuals in the 39.6% tax bracket are subject to a 20% tax on dividends. Higher-income taxpayers are also subject to a 3.8% Medicare surtax on investment income.
In order to be a "qualified dividend," the dividend must be issued by a U.S. corporation or a foreign company that either trades on a U.S. exchange, such as an ADR, or is eligible for benefits under a U.S. tax treaty.
Note that in order for the dividend to be "qualified," you must have owned the investment for at least 60 days of the 121-day period that begins 60 days before the ex-dividend date, or the day the stock trades without the dividend priced in. (If that's as clear as mud, hopefully this article can shed some light.)
Foreign Stocks With Nonqualified Dividends
If you're considering a foreign stock for a taxable account, do your homework on whether the company's dividends are qualified. You can find out more about this by consulting IRS Publication 17.
In many (but not all) cases, preferred-stock dividends are treated as qualified dividend income for tax purposes, even though they have many bondlike characteristics, such as a stated par value and fixed coupon.
Some dividends paid by U.S. companies are not eligible for lower tax rates, however. Here are a few examples:
Real estate investment trusts do not pay income taxes at the corporate level, but they are required to pay annually at least 90% of their taxable income in the form of shareholder dividends, which is one reason they pay out such large dividends.
Different types of REIT payments are taxed at different rates. In the majority of cases, REIT dividends are considered nonqualified and taxed at ordinary income rates; therefore, they are probably best held in a tax-advantaged account. But there are other types of income payments, such as those distributed from taxable REIT subsidiaries or out of long-term capital gains, which could be subject to lower tax rates; investors should consult with their tax advisors in these cases.
Master limited partnerships are partnerships that trade on a public exchange. They may offer certain tax benefits but also some tax complexity. Unlike with REITs, however, it's best to hold MLPs in a taxable account, because owning them in a tax-deferred account can result in something called unrelated business taxable income, which then requires the account to pay taxes.
MLPs pass through their taxable income to unitholders, who then pay taxes on that income at their own marginal tax rates, often only when the units are sold. These can be a little complicated at tax time, owing to the fact that you don't use a 1099 form to report the distributions but instead have to use a K-1.
Another interesting feature of MLPs is that cash distributions are not directly taxable: The IRS looks at them as returns of capital, so it reduces the investor's cost basis in the MLP. In practical terms, that means that the investor will have to pay taxes on the spread between a lower cost basis and the MLP's price at the time of the sale, but most of the income the MLP distributes from year to year is effectively tax-deferred. For more on this, see this article.
Exchange-traded products can sometimes sidestep tax-reporting complexities, but oftentimes at the expense of the tax benefits one would get if the MLPs were held directly. For more on that, see this article.
Bond income is generally taxed at investors' ordinary income tax rates in the year it was received. The income is taxable at the federal level in all cases, but Treasury bonds are not subject to state and local income taxes.
As with Treasury bonds, interest payments from Treasury Inflation-Protected Securities (TIPS), and increases in the principal of TIPS, are subject to federal tax, but exempt from state and local income taxes. One additional thing to remember about TIPS, however, is that the amount by which the principal of your TIPS increased due to inflation is taxable for the year in which it occurs, even if your TIPS hasn't matured (in other words, before you would receive an actual payment of principal).
Muni bonds are issued by state and local governments to finance public projects. In the vast majority of cases, the income paid out by these bonds is not taxed at the federal level. In some instances (particularly if the bond is issued by a state or municipality in which you reside), munis' income is not taxed at the state or local level, either. For more on this, see this article. It's also worth noting that income from private-active munis is subject to the Alternative Minimum Tax.
There are typically no dividend or interest payments paid to investors who get exposure to commodities through exchange-traded note (which is an unsecured debt obligation) or grantor trust (which often holds physical commodities) structures. However, if you bought a commodity-futures-based exchange-traded note, you might have to report income using a Schedule K-1. For more on this, see this article.
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