Investment Tax Basics

Ordinary income

Examples of ordinary income include wages, tips, commissions, alimony, and rental income. Investments often produce ordinary income in the form of interest. Many investments — including savings accounts, certificates of deposit, money market accounts, annuities, bonds, and some preferred stock — can generate ordinary income. Ordinary income is taxed at ordinary, or regular, income tax rates.

Capital gain and loss

If you sell stocks, bonds, or other capital assets for more or less than you paid for them, you'll end up with a capital gain or loss. Special capital gain tax rates may apply. These rates may be lower than ordinary income tax rates.

Understanding basis

Generally speaking, basis refers to the amount of your investment in an asset. Your initial basis usually equals your cost — what you paid for the asset. For example, if you purchased one share of stock for $100, your initial basis in the stock is $100. However, your initial basis can differ from the cost if you did not purchase an asset but rather received it as a gift or inheritance, or in a tax-free exchange.

Your initial basis in an asset can increase or decrease over time. For example, if you buy a house for $100,000, your initial basis in the house will be $100,000. If you later improve your home by installing a $5,000 deck, your adjusted basis in the house may be $105,000. You should be aware of items that increase or decrease the basis of your asset. For a detailed discussion of basis and adjustments to basis, see IRS Publication 551, Basis of Assets.

Calculating gain or loss

Capital gain (or loss) equals the amount that you realize on the sale of your asset (i.e., the amount of cash and/or the value of any property you receive) less your adjusted basis in the asset. If you sell an asset for more than your adjusted basis, you'll have a capital gain. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $15,000, your capital gain will be $5,000. If you sell an asset for less than your adjusted basis in the asset, you'll have a capital loss.

Short term vs. long term

Generally, the amount of time that you've owned an asset is referred to as your holding period. A capital gain is classified as short term if the asset was held for one year or less, and long term if the asset was held for more than one year.

Whether your capital gain is classified as short term or long term can make a difference in how you calculate tax. Short-term capital gains are taxed at the same rate as your ordinary income. The tax rates that apply to long-term capital gains, however, are generally lower than ordinary income tax rates.

Long-term capital gain

Special tax rates apply to ong-term capital gains. The maximum tax rate at which your long-term capital gains are taxed depends on which federal income tax rate bracket you fall into.

If your taxable income places you in the lowest two tax brackets for ordinary income tax purposes, a 0% tax rate generally applies to long-term capital gains. So, for 2017, if your filing status is single and your taxable income is less than $37,950, you'll generally pay no tax on long-term capital gains.

If you're in the 25%, 28%, 33%, or 35% tax brackets, the maximum rate that applies to long-term capital gains is generally 15%. If you're in the top federal tax bracket (39.6%), the maximum tax rate that applies is generally 20%.

Qualified dividends

If you receive dividend income, it may be taxed either at ordinary income tax rates or at the rates that apply to long-term capital gain income. If the dividends are qualified dividends, they're taxed at the same tax rates that apply to long-term capital gains. Qualified dividends are dividends paid to an individual shareholder from a domestic corporation or a qualified foreign corporation, provided that you hold the shares for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (a longer holding period requirement applies to dividends paid by certain preferred stock).

Some dividends (such as those from money market funds) continue to be treated as ordinary income. Generally, ordinary dividends are shown in box 1a of Form 1099-DIV, while qualified dividends are shown in box 1b.

Tax-exempt income

Some income is specifically exempted from federal income tax. For example, while the interest on corporate bonds is subject to tax at the local, state, and federal level, interest on bonds issued by state and local governments (generically called municipal bonds, or munis) is generally exempt from federal income tax. If you live in the state in which a specific municipal bond is issued, it may be tax-free at the state or local level as well. Note that the income from Treasury securities, which are issued by the U.S. government, is exempt from state and local taxes but not from federal taxes.

Net investment income tax

High-income individuals generally face an additional 3.8% net investment income tax (also referred to as the unearned income Medicare contribution tax) on unearned income. This surtax is equal to 3.8% of the lesser of:

• Your net investment income
• The amount of your modified AGI (basically, your AGI increased by an amount associated with any foreign earned income exclusion) that exceeds $200,000 ($250,000 if married filing jointly, $125,000 if married filing separately)

So if you're single and have modified AGI of $250,000, consisting of $150,000 in earned income and $100,000 in net investment income, the 3.8% net investment income tax will apply only to $50,000 of your investment income.

Net investment income generally includes all net income (income less any allowable associated deductions) from interest, dividends, capital gains, annuities, royalties, and rents. It also includes income from any business that's considered a passive activity, or any business that trades financial instruments or commodities.

Tax-advantaged savings vehicles

Taxes can take a bite out of your total investment returns, so it's helpful to consider tax-advantaged savings vehicles when building a portfolio. Some tax-advantaged savings vehicles allow you to defer paying taxes on earnings until some point in the future, while other tax-advantaged savings vehicles allow earnings to escape taxation altogether under certain circumstances.

Tax-advantaged savings vehicles for retirement

Traditional IRAs: Anyone under age 70½ who earns income or is married to someone with earned income can contribute to a traditional IRA. Depending upon your income level and whether you're covered by an employer-sponsored retirement plan, you may or may not be able to deduct your contributions to a traditional IRA. Your contributions always grow tax deferred, but you'll owe income taxes when you make a withdrawal.* For 2017, you can contribute up to $5,500 to an IRA, and individuals age 50 and older can contribute an additional $1,000.

Roth IRAs: Roth IRA contributions can be made only by individuals with incomes below certain limits. Your contributions are made with after-tax dollars but will grow tax deferred, and qualified distributions (those satisfying a five-year holding period and made after age 59½ or after becoming disabled) will be tax free when you withdraw them. The amount you can contribute is the same as for traditional IRAs. Total combined contributions to Roth and traditional IRAs cannot exceed $5,500 for 2017 for individuals under age 50.

SIMPLE IRAs and SIMPLE 401(k)s: These plans are generally associated with small businesses. As with traditional IRAs, your contributions grow tax deferred, and you'll owe income taxes when you make a withdrawal.* For 2017, you can contribute up to $12,500 to one of these plans; individuals age 50 and older can contribute an additional $3,000. (SIMPLE 401(k) plans may also allow Roth contributions.)

Employer-sponsored plans (401(k)s, 403(b)s, 457 plans): Contributions (typically made on a pre-tax basis) to these plans grow tax deferred, but you'll owe income taxes when you make a withdrawal.* For 2017, you can contribute up to $18,000 to one of these plans; individuals age 50 and older can contribute an additional $6,000. Employers generally allow employees to make after-tax Roth contributions in lieu of pre-tax contributions, in which case qualifying distributions will be tax-free.

Annuities: You pay money to an annuity issuer (an insurance company), and the issuer promises to pay principal and earnings back to you or your named beneficiary in the future (you'll be subject to fees and expenses that you'll need to understand and consider). Annuities generally allow you to elect an income stream for life (subject to the financial strength and claims-paying ability of the issuer). There's no limit to how much you can invest, and your contributions grow tax deferred. However, you'll owe income taxes on the earnings when you start receiving distributions.*

*Withdrawals prior to age 59½ may be subject to a 10% federal income tax penalty unless an exception applies (the penalty may be 25% in the case of a SIMPLE IRA if withdrawals are taken within two years of beginning participation in the plan).

Tax-advantaged savings vehicles for college

529 plans: College savings plans and prepaid tuition plans let you set aside money for college. Your contributions grow tax deferred and can be withdrawn tax-free at the federal level if the funds are used for qualified education expenses.** These plans are open to anyone regardless of income level. Contribution limits are high — typically over $300,000 — but vary by plan.

Coverdell ESA: Coverdell Education Savings Accounts are open only to individuals with incomes below certain limits. But if you qualify, you can contribute up to $2,000 per year, per beneficiary. Your contributions grow tax deferred and can be withdrawn tax free at the federal level if the funds are used for qualified education expenses.**

**Earnings are subject to federal income tax and potentially a 10% penalty tax if the funds are not used for qualified education expenses.