How 3 Different Types Of Investment Income Are Taxed (Introduction for Beginners)

Miranda Marquit for istockanalyst writes: As you probably know, our tax system is far from straightforward. Not only are there a number of different deductions and credits to take into accounts, and various tax brackets to consider, but even your income falls into different categories.

You can't even rely on a division between "regular" income that you receive at a traditional job and investment income received as a result of your careful division of resources. As you fill out your tax return, you will find that even your investment income is divided into different categories and taxed differently.

Interest Income

When you invest in cash products, like high yield savings accounts and CDs, or in bonds (municipal bonds aren't taxed at a federal level, though), you are likely to earn interest. The interest you earn is taxed in a fairly straightforward manner: It's added to your regular income and taxed at your marginal rate.

In most cases, your interest income is taxed in the year that you receive it, even if it is reinvested and you never actually hold the money in your hands. Some CDs automatically reinvest your interest earnings back into the CD, and if this is the case, you will receive a 1099-INT describing how much you have earned that year.

There are some cases in which bond interest and CD interest isn't paid out until the investment matures. In these cases, you are responsible to pay taxes on the interest you receive at the end of the term, when you receive the interest.

Capital Gains

A capital gain is the increase that you see when you sell an asset for more than you bought it for. So, if you spend $1,000 on an asset, and a few years later you sell it for $2,500, you have a capital gain of $1,500. This is the amount that you are taxed on.

The good news about capital gains, though, is that they are taxed at a preferred rate – if you have held the asset long enough. There are two types of capital gains income:

1. Long term: If you have held the asset for more than a year (so you need to hold the asset for at least a year and a day), you receive a preferred tax rate. You pay 0% on the income if you fall into the 10% or 15% tax brackets. If you fall into the marginal tax brackets ranging from 25% to 35%, you will pay a capital gains tax of 15%. Those who fall into the highest tax bracket (39.6%) pay a capital gains tax of 20%. In any case, you pay less on long term capital gains than you would normally pay on income.
2. Short term: For capital assets held for a year or less, you pay at your marginal tax rate.

Your tax planning requires you to consider the impact of how long you hold your assets before selling.

Dividend Income

Your dividend income is taxed at a preferred rate as well. As long as your dividend income is "qualified," your dividend income is taxed at the long term capital gains rate – at least for now. Dividend income is subject to the possibility of reverting to being taxed as regular income in the year it is earned.

Pay attention to the type of investment income you have, and plan your investment and tax strategy accordingly.