The Ins and Outs of Tax on “Income Investments”

Income investments pay interest or dividends to the holder but often trade that benefit for less growth in value than other investments offer. This can be especially appealing to risk-adverse investors, but not all income investments are alike when it comes to taxes. It’s essential to understand the varying tax treatments when managing your income investments and building your portfolio.

Differing tax treatment

The tax treatment of investment income varies partly based on whether the income is in the form of dividends or interest. Qualified dividends are taxed at your favorable long-term capital gains tax rate (currently 0%, 15% or 20%, depending on your tax bracket) rather than at your ordinary-income tax rate (which might be as high as 39.6%). Interest income generally is taxed at ordinary-income rates. So stocks that pay dividends might be more attractive tax-wise than interest-paying income investments, such as CDs and bonds.

But there are exceptions. For example, some dividends aren’t qualified and therefore are subject to ordinary-income rates, such as certain dividends from:

  • Real estate investment trusts (REITs)
  • Regulated investment companies (RICs)
  • Money market mutual funds
  • Certain foreign investments

Also, the tax treatment of bond interest varies. For example:

  1. Interest on U.S. government bonds is taxable on federal returns but exempt on state and local returns.
  2. Interest on state and local government bonds is excludable on federal returns. If the bonds were issued in your home state, interest also might be excludable on your state return.
  3. Corporate bond interest is fully taxable for federal and state purposes.

One of many factors

Keep in mind that tax reform legislation could affect the tax considerations for income investments. For example, if your ordinary rate goes down under tax reform, there could be less of a difference between the tax rate you’d pay on qualified vs. nonqualified dividends.

Contact us

While investment decisions shouldn’t be driven by tax treatment alone, it is important to factor everything into your income investment strategy. If you have questions or want help factoring taxes into your investment strategy, JLK Rosenberger can help. For more information, call us at 949-860-9902 or click here to contact us.

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