As an investor, one of your major responsibilities is understanding the implications that taxes can have on your overall financial plan, portfolio strategy, and investment income.

Transactions that result in realized capital gains are among the most common reasons you may owe taxes as an investor. Portfolio income, like dividends and interest from bonds, is another reason why you may be subject to portfolio income taxation.

This article will discuss what goes into portfolio income taxation. We will also cover what you should keep in mind regarding the subject as an investor.

Before we continue, Financial Professional wants to remind you that all materials in this article are educational in nature. This article is not investment advice. Always consider your personal situation – and the help of a licensed financial professional – when making any investment decisions. 

What Is Investment Income?

Portfolio income – or investment income – refers to any type of income that comes from holdings within your investment portfolio. The most common sources of portfolio income are:

You can reinvest your investment income back into your portfolio. Alternatively, you can withdraw it to supplement other income streams that an investor may have.

It Depends On The Account

The type of account that holds the investments that yields the investment income is probably the most important consideration when it relates to your taxes. Any income that is earned in tax-deferred accounts, like IRAs, 401Ks, pensions, etc. is NOT taxable in the year that the portfolio income is earned.

But why?

Remember, the only time that taxes apply within these accounts is when the account holder withdraws the funds. In that case, any amount you withdraw is added to the taxpayer’s income in the tax year of the withdrawal. This is true whether the income originates from either capital gains or other portfolio income. The 10% early withdrawal penalty may also apply.

Portfolio income, on the other hand, is ONLY currently taxable if it is earned in a taxable brokerage account. Typically, the income earned within a brokerage account is taxable as ordinary income. This means the earnings may be taxable at whatever the taxpayer’s federal and (if applicable) state marginal tax rate is.

As an over-simplified example, if an investor earned $50,000 (pre-tax) from their annual salary and $3,000 from portfolio income, they would have $53,000 subject to ordinary income taxation. Again, this only applies if the earnings occur within a taxable brokerage account.

Note: If you earned portfolio income in a taxable brokerage account, you must report it, whether you reinvested the funds or not.

Exceptions

There are securities that provide investors with income that may be exempt from ordinary income taxation.

Municipal bonds offer interest that is completely exempt from federal income taxation. If the taxpayer resides in the state that issued the bond, the interest may be exempt from state income taxation, as well.

If you own a mutual fund that invests in municipal securities, you may receive exempt-interest dividends from the fund. That interest is also exempt from federal income taxation, however, state income taxes may apply.

Qualified Dividend Rates

If you meet certain criteria, you may be able to receive favorable tax treatment when it comes to dividends from stocks that you hold in your portfolio.

Qualified dividend rates are much lower than ordinary federal income tax rates. They mirror long-term capital gains rates (0%, 15%, or 20% depending on your tax bracket).

Here are the requirements for dividends to receive this favorable tax treatment, according to the IRS:

  • The dividend must come from a U.S. company or a qualifying foreign company.
  • Dividends are not listed with the IRS as those that do not qualify
  • The required dividend holding period has been met

Here is how the IRS defines the holding period requirement: “Common stock investors must hold the shares for more than 60 days during the 121-day period that starts 60 days before the ex-dividend date, or the date after the dividend has been paid out and after which any new buyers would then be eligible to receive future dividends. For preferred stock, the holding period is more than 90 days during a 181-day period that starts 90 days before the ex-dividend date.”

At lower levels of portfolio income, qualified dividend taxation may not make a huge difference, but it can definitely make a material difference as your portfolio continues to provide higher levels of dividends.

Capital Gains as Investment Income

Transactions that result in realized capital gains can still provide you with a form of investment income, even though it isn’t technically classified as portfolio yield. There are two types of capital gains tax rates: short-term and long-term.

Sales of securities, held for a year or less, which result in a capital gain, are generally taxable as ordinary income. In other words, the amount of the gain is added to the taxpayers “pre-tax income” in the tax year of the transaction. This is a short-term capital gain.

Long-term capital gains rates tend to be more favorable. The current long term capital gains rates are 0%, 15%, and 20%.

The capital gains rate that you fall under depends on your taxable income and the amount of the gain realized from the transaction. Most people fall under the 15% rate.

Portfolio Income Planning

Depending on your level of assets and need for financial planning, it may be worth going through some financial planning to determine a strategy that is appropriate for you.

Here are some variables to plan around:

  • Inflation
  • Your entire portfolio of assets, asset allocation, and “tax buckets”
  • Your current vs future expected tax rates
  • Other streams of income
  • Other financial goals

Typically, you don’t have to worry about this level of planning until you have a sizable enough portfolio of assets that can provide you with enough yield to actually supplement your other sources of income. For retirees, this may be a pension and social security. For others, it may be income from real estate and other business operations.

A Final Word on Investment Income Taxes

Portfolio income is one of the purest forms of passive income. Reinvesting dividends and bond interest can accelerate the wealth creation process. However, you must familiarize yourself with the tax rules associated with your investment income, even if you reinvest the funds back into your portfolio.

The primary consideration is the type of account earning the income in the portfolio. If the income is earned within a tax-deferred account, then taxation is a non-issue. On the other hand, if a taxable account earns the funds, then you must report the income.

If your tax situation is complex enough, it may be worth consulting a tax professional when planning around your current and future portfolio income. Keep other variables like inflation, your current/future tax rates and other financial goals in mind.

Have questions on portfolio income? Let us know!

Jose Hernandez
Jose Rafael Hernandez is known as "The Millennial Money Mentor" on social media. He and his family are immigrants to the United States from Venezuela. The unique challenges that he faced at a young age taught him the real value of money and its importance in life. Jose studied finance at Mercer University, where he also competed in Division 1 Baseball. After his athletic career, Jose began his professional career in the finance industry. He started his career as a wealth management advisor for one of the top Investment Advisory firms in the US, where he was responsible for just north of $20mm in AUM. Jose currently holds the Series 7 and 66 licenses. Jose decided to leave the firm so he could have the freedom to create his brand on social media, geared towards educating millennials in the areas of personal finance and investing. His mission is to leave a positive impact on others while building his own legacy and providing for his family.

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