2.3 Taxation of Investment Income
This chapter covers how the IRS sorts income into earned, passive and portfolio categories, how dividends and interest are taxed, and how cost basis and holding periods decide the tax on a capital gain. Series 65 questions on these topics turn on a handful of rules and rates. The same rules tell an adviser what a client keeps after taxes on investment returns.
What each topic covers
The lesson on earned, investment and passive income separates the three categories the IRS recognizes. Earned income comes from wages, salaries, tips, bonuses and commissions and is taxed at the marginal bracket. Social security, unemployment benefits, alimony, child support and retirement benefits do not count as earned income. Investment income covers dividends, interest and capital gains, and realized gains and losses are netted against each other. Up to $3,000 of a net capital loss can be deducted against earned income each year, and the rest carries forward. Passive income from rental real estate and limited partnerships is taxed at ordinary rates, but passive losses can only offset passive gains. The lesson closes with the alternative minimum tax, where the taxpayer pays the higher of two calculations.
The lesson on qualified dividends and interest tax shows why a dividend’s classification sets its rate. Qualified dividends are taxed at 0%, 15% or 20%, and a question that gives no rate can be answered with 15%. To qualify, a dividend must come from a US or qualified foreign corporation and meet an unhedged holding period. Non-qualified dividends and interest are taxed at the investor’s federal marginal bracket, up to 37%, and REIT dividends are always non-qualified. For interest, the issuer matters: US government debt is exempt from state and local tax, municipal debt is exempt from federal tax, and corporate debt is fully taxable. Dividends are reported on Form 1099-DIV for the year they are paid, and interest on Form 1099-INT.
The lesson on cost basis and capital gain holding periods starts with the arithmetic. Cost basis is the purchase price plus commissions, sales proceeds are the sale price minus commissions, and the difference is the gain or loss, reported on Form 1099-B. A position held more than one year (one year and one day) produces a long-term gain taxed at 0%, 15% or 20%. One year or less produces a short-term gain taxed at ordinary rates, as high as 37%. Inherited securities get a stepped-up basis equal to their value on the date of death and are always long term. Gifted securities keep the original owner’s basis and holding period. The worked example puts the tax at $1,500 on inherited shares and $19,200 on the same shares received as a gift.