Investment Income Can Be Tricky At Tax Time—Here’s What You Need To Know

The majority of taxable income in America comes from wages and salaries—typically, those numbers are reported on Form W-2 at tax time. For the 2021 tax year (the last year that complete data is available), nearly 80% of taxpayers reported salaries and wages for a combined total of more than $9 trillion.

But that doesn't account for all taxpayers—or all taxable income. Taxpayers also reported nearly $2.7 trillion in investment income in 2021. That included almost $160 billion in interest and $387 billion in dividends. But the real standout? Nearly $2.1 trillion in sales of capital assets—another $51 billion was attributable to sales of property other than capital gains.

In the same year, taxpayers reported over $408 billion in taxable IRA distributions, with more than $858 billion of taxable pensions and annuities income. Add in an additional $413 billion in taxable Social Security benefits for nearly $1.7 trillion in taxable retirement income.

That's a lot of income that doesn't fit neatly on line 1a of your Form 1040 (and that doesn't include business income or income from partnerships and s corporations).

The rules that apply to investment income can be tricky—and require close attention. Here are a few line items to keep in mind as you navigate your tax return.

Taxable Interest

Interest is reportable at the first dollar—though you typically won't receive a Form 1099-INT, 1099-INT, Forms 1099-OID, or substitute statement unless you receive $10 in taxable interest for the year. Reportable interest may include interest from your bank or brokerage account and interest from series EE, H, HH, and I savings bonds—exclusions may apply. For example, under the Education Savings Bond Program, you may be able to exclude from income all or part of the interest you receive on the redemption of qualified U.S. savings bonds during the year if you pay qualified higher education expenses during the same year (you do not qualify for the exclusion if your filing status is married filing separately).

Interest income also includes interest from Treasury bills, notes, and bonds. You'll report it on Form 1040 since that interest is subject to federal income tax (it is exempt from state and local income taxes).

Interest income also includes interest on loans you make to others.

And, finally, *whispering* interest you receive on tax refunds is taxable income. (Don't shoot the messenger.)

Normally, you'll report taxable interest on line 2b on the front page of Form 1040, but if your taxable interest income is more than $1,500, you must also include that income on Schedule B.

Tax-Exempt Interest

Tax-exempt interest may include interest from bonds issued by states, cities, or counties and the District of Columbia. It may be reportable even if it's not taxable for federal income tax purposes—though in some cases, it may be subject to the alternative minimum tax (AMT).

If you receive tax-exempt interest, report the net amount on line 2a.

Asset Location

You won't include interest earned on your IRA, health savings account, Archer or Medicare Advantage MSA, or Coverdell education savings account on your Form 1040. That's a crucial distinction for taxes, making asset location an important consideration for your finances.

Here's why that matters. If all your investments are in one place, there's nothing to decide. However, for taxpayers who have assets in a traditional bank or brokerage account and a retirement account, it may be time to have a discussion with your financial advisor. Assets that throw off a lot of income are ideal for tax-favored retirement accounts, like IRAs, 401(k)s, and 403(b)s. In contrast, low-dividend stocks may produce less income and be perfect for your traditional bank or brokerage accounts.

Dividends

We often think of dividends as money associated with shares of stock—that's because most dividends are paid in cash. But dividends can be distributions of money, stock, or other property paid by a corporation or mutual fund. You can also receive dividends through a partnership, estate, trust, or an association taxed as a corporation.

Typically, your dividends will be reported to you on Form 1099-DIV. But, as with interest and Form 1099-INT, you must report all your taxable dividend income even if you don't receive a form.

Ordinary dividends are taxed as ordinary income. A good rule of thumb? Assume that any dividend you receive on common or preferred stock is an ordinary dividend unless the corporation or mutual fund tells you otherwise.

For example, amounts you receive from money market funds are dividend income. That's because money market funds are a type of mutual fund and not bank money market accounts that pay interest.

Ordinary dividends will be shown in box 1a of Form 1099-DIV.

Qualified Dividends

Qualified dividends are taxed at different rates than ordinary dividends. Ordinary dividends are taxed as ordinary income, while qualified dividends are taxed at capital gains rates.

Generally, qualified dividends must be paid by a U.S. corporation or a qualified foreign corporation and held for at least 61 days out of a 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the first date after the declaration of a dividend on which the buyer of a stock is not entitled to receive the next dividend payment. When counting the days you held the stock, include the day you disposed of the stock but not the day you acquired it.

The holding period is different for preferred stock. In that case, you must have held the stock for more than 90 days during the 181-day period that begins 90 days before the ex-dividend date if the dividends are due to periods totaling more than 366 days. If the preferred dividends are due to periods totaling less than 367 days, the holding period in the preceding paragraph applies.

Confused? The corporations—or your broker—should do the math for you. Qualified dividends will be marked as such on line 1b of your Form 1099-DIV.

Capital Gains

For tax purposes, you figure your capital gains or losses by determining how much your basis—typically, the cost you pay for assets—has gone up or down from when you acquired the asset until there's a taxable event. A taxable event can include a sale, gift, or other disposition.

When it comes to stocks, your basis is generally equal to the original cost of the shares. If you participate in a DRIP or other reinvestment plan, your basis is your cost plus the cost of each subsequent purchase/reinvestment subject, of course, to adjustments for splits and the like. Gains and losses aren't determined moment to moment but instead by how much your cost basis has gone up or down from the time you acquired the asset to the disposition of the asset—those are called realized gains or losses.

• If you hold an asset for more than one year before a taxable event, it's considered a long-term gain or loss subject to tax-favored rates. There are three long-term capital gains brackets (0%, 15% and 20%) based on filing status and income.
• If you hold an asset for one year or less before a taxable event, it's considered a short-term gain or loss. Short-term capital gains are taxed at ordinary income tax rates. The rates and brackets for 2023—the return you're filing now—are here. (You can find the 2024 tax rates and brackets here.)

At tax time, you'll report your realized gains and losses on a Schedule D and then transfer the results to the reconciliation page on Form 1040. You don't file Schedule D if you don't have any realized gains or losses—even if the value of your shares went up and down significantly, if there was no sale or disposition, there's nothing to report.

If your realized losses exceed your realized gains, you have a capital loss for tax purposes. You can claim up to $3,000 (or $1,500 if you are married filing separately) of capital losses in any tax year. The amount of your loss offsets your taxable income for the tax year. If your losses exceed those limits, you can carry the loss forward to later years subject to certain limitations.

Tax-Loss Harvesting & Wash Sales

A strategy that some taxpayers use to offset capital gains is tax-loss harvesting. With harvesting, you sell stocks that are losing money and then use the loss to offset capital gains in different accounts.

The ability to harvest losses is a potential benefit of direct indexing. Direct indexing happens when you buy the individual stocks of an index (think S&P 500) to replicate the index's performance (you can't invest directly in an index).

When you sell stocks to offset losses, you can lower your taxes. Practically speaking, most taxpayers reinvest the proceeds. With direct indexing, you'll want to reinvest those into a similar position—to keep the index consistent. But, be careful not to run afoul of the wash sale rules—under those rules, if you sell a security at a loss, you can't buy the same or a similar security within 30 days before or after the sale. If you do, you lose the ability to claim the loss.

Other Assets

Other limits and restrictions may also apply depending on the kind of assets. For example, you may not claim a capital loss for a personal residence. You can, however, have a gain.

Some taxpayers believe that any profit on the sale of a home is taxable—but that's not true. There is an exclusion on capital gains up to $250,000 ($500,000 for married taxpayers) on the gain from the sale of your main home. That exclusion is available to all qualifying taxpayers—no matter your age—who have owned and lived in their home for two of the five years before the sale.

Exceptions and special rules may apply to small businesses, retirement assets, and other circumstances, as well as adjustments related to calls, puts, and straddles. Special rules also apply to artwork, real estate, and other assets, especially as they pertain to capital losses and carryforwards.

Compensation-Related Investments

Typically, compensation is taxable as ordinary income. But sometimes, employers may pay you with a stake in the company instead of cash—although the stake isn't always stock. That compensation—called equity compensation—can include stock options, restricted stock units, phantom stock, and stock appreciation rights.

It's essential to keep any documentation your company might provide you since equity compensation can be taxed as ordinary income, capital gains, or a mix of the two. For example, restricted stock units (RSUs), typically tied to a vesting schedule, are treated as ordinary income at vesting. But, once they're vested, the shares belong to you outright, and any subsequent sales are subject to capital gains treatment. In contrast, phantom shares don't have an ownership interest piece, so the tax treatment of any related compensation is treated as ordinary income.

Cryptocurrency

The IRS considers cryptocurrency a capital asset. In 2014, the agency issued guidance making it clear that capital gains rules apply to any gains or losses.

• If you buy and sell cryptocurrency as an investment, you'll calculate gains and losses the same way you buy and sell stock.

• If you treat cryptocurrency like cash—spending it directly for goods or services or using it to buy other digital assets—the individual transactions may result in a gain or a loss.

And while the value of cryptocurrency goes up and down, you care the most about the beginning and the end—what happens in the middle doesn't count. That's because, for tax purposes, when cryptocurrency takes a dive, that doesn't equal a realized loss. Similarly, when it goes back up in value, that doesn't equal a realized gain. To realize a gain or a loss for tax purposes, you must do something with the asset, like sell or otherwise dispose of it. (Those are the same rules for other capital assets.)

One more note: It's been suggested that if your cryptocurrency has substantially dropped in value, you can claim it as a loss under section 165. In January 2023, the IRS Office of Chief Counsel issued Memorandum 202302011. The "non-taxpayer specific advice" confirmed two things:

1. If you lose most of the value of your cryptocurrency, it's not worthless—it still has value. That means that you don't have a sustained loss under section 165.
2. Even if you sustained an actual loss under section 165, the loss would be disallowed because section 67(g) suspends miscellaneous itemized deductions for taxable years 2018 through 2025 (some exceptions apply).

The memorandum references Lakewood Assocs. v. Commissioner, 109 T.C. 450, 459 (1997), claiming, "The mere diminution in value of property does not create a deductible loss." In other words, if it's not wholly worthless, you still own something and there's no realized loss.

It's worth re-emphasizing that the IRS memo is a response to a "request for non-taxpayer specific advice," meaning it "should not be used or cited as precedent." It doesn't carry the same weight as a law or regulation. However, it does offer insight into how the IRS regards an issue, and that's valuable information.

Extra Reporting

It may also be the case that you have to report certain assets even if they aren't producing U.S. taxable income. That includes assets like stock in a foreign corporation—you may also need to file specific forms if you've bought, inherited, been gifted, or otherwise acquired assets outside of the U.S.

Net Investment Income Tax (NIIT)

And don't forget about the Net Investment Income Tax (NIIT). Since 2013, taxpayers have been subject to a surtax of 3.8% on certain net investment income if their modified adjusted gross income (MAGI) is over $200,000 for individuals and heads of household ($250,000 for married taxpayers filing jointly and $125,000 for married taxpayers filing separately). Those amounts aren't adjusted for inflation.

The tax is figured on the lesser of your net investment income or the amount of your MAGI over the threshold amount.

For purposes of the NIIT, investment income generally includes taxable interest (but not tax-exempt interest), dividends, and capital gains. Some other investment income, like rental and royalty income, may also apply. You don't include earned income, such as salaries and wages, business income and Social Security benefits do not apply.

More Information

Even though this feels like a lot, it’s just a look at the basics—this is also tax law, so there may be additional rules and regulations, exceptions, and exemptions. If you have specific questions, check with your tax professional.

For a deeper look at investment income and tax, join Forbes editor Janet Novack, Forbes contributor Amber Gray-Fenner, and me as we navigate some of the tricky waters surrounding the tax treatment of investments. The free webinar is slated for March 26, 2024, at 2:00 p.m. ET. Register here.

You can also check out IRS Pub. 550.

And, finally, don't forget about our free Forbes tax guide.

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