Understanding Your Net Investment Income Tax

Understanding your net investment income tax is not as easy as you would hope. This is because the tax rate on investment income varies depending on how the investment income is earned. This means that two people with the same amount of total investment income could owe a different amount of tax on investment income if it were earned in different ways.

There are tax efficient investing habits you can learn that will reduce your annual income tax bill. These include investment tax credits and retirement plan investing.

Taxes on Investing Capital Gains

If you spend $2,000 to buy a stock and sell it later for $3,000, this results in a gain of $1,000, which is taxable. How much tax you pay on that $1,000 gain depends on how long you owned the stock before selling it.

If you held the stock for less than a year, the $1,000 of income is taxed as a “short-term capital gain”. This is taxed at the rate of your ordinary income, which could be as high as 37%.

If you held that same stock for at least a year, the $1,000 gain is considered a “long-term capital gain” and is taxed at a reduced rate that will not exceed 20%.

So you can see the Internal Revenue Service encourages investors to hold their stocks for the longer term by reducing the tax rate on long term capital gain. If you are going to trade in and out of stocks, not holding them for at least a year, the Internal Revenue Service will tax your gains at the higher rate.

In addition, on capital gains, you get to offset your short and long-term gains with any short and long-term losses before calculating the income tax due.

Taxes on Dividend Income

Tax on investment income from dividends can also be a bit confusing. Like the taxes on investing capital gains discussed above, the tax rate on investment income from dividends varies based on a couple of factors.

If you receive “qualified” dividend income (as determined by the Internal Revenue Service), your net investment income tax rate will not exceed 20%. This is equal to the tax rate long-term capital gains discussed above.

If the dividends are determined to be “non-qualified” then they are taxed as ordinary income, which can be as high as 37%.

Most of the dividends received from United States based companies will be considered qualified dividends. But be sure to check if a company’s dividends will be qualified or unqualified before making an investment.

Tax Efficient Investing

Obviously we want to save as much as we possibly can by paying the lowest amount on the net investment income tax.

As you can tell from the above discussion, the federal income tax rate on investment income can be as high as 37%. And that does not even include any taxes you will pay at the state level, which can add another 10%+ to your tax bill.

This creates a huge incentive for tax efficient investing decisions throughout the course of your investing journey. Here are our top four things you can do to reduce the tax on investment income.

The first two are a recap from above:

Hold any investment for at least a year to get the lower capital gains tax rate when you do sell. This is in line with what we have been discussing at Wealthplicity for some time now, which is to invest in businesses for the long term, rather than to trade in and out of stocks on a weekly basis.

Not only do we think you will sleep better at night, but you will clearly pay less taxes on any gains from those trades.

If you invest in dividend stocks, make sure the dividends are qualified, so you are taxed at a lower rate.

These next two things are additional tax efficient strategies:

Put as much money away as possible into retirement accounts, such as your work sponsored 401K plan, or an individual retirement account (IRA).

Any income you place into these kinds of retirement plans are not taxed in the year that you earn the money, but instead is deferred til many years later, when you withdraw the money. Given that during your retirement years you should be earning less, the tax rate on the withdrawn money should be less than you would of paid in the year that you originally earned it.

These retirement accounts are considered tax deferred accounts. That is because you are not avoiding the tax all together, just deferring it to a later time.

This is likely the number one thing that you can do for your financial health. Not only is it a great tax efficient investing strategy, but it is also a great incentive to get you to start investing for your retirement years before it is too late.

Investment tax credits are perhaps the most tax efficient investing strategy. This is because investment tax credits don’t just defer the taxes, but they eliminate them.

Investment tax credits are an incentive by the federal government for you to invest in something. If you qualify, then depending on the item you may get a dollar-for-dollar reduction in your tax bill for what you invested in, or you may get a partial tax reduction.

The latest example of a popular investment tax credit is the Solar Investment Tax Credit (ITC).

The ITC was first enacted in 2006 when the solar industry was in its infancy. The ITC was a clear incentive for folks to invest in solar panels for their home or business. Not to mention it was the right thing to do for the environment.

Today the ITC still allows a tax credit equal to 26% of the cost of a qualified solar panel system that you purchase. On a $10,000 investment you get an immediate $2,600 federal tax deduction in the year you made the purchase. That is very attractive.