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Taxation of Income, Capital Gains, and Interest

When you receive income, it’s likely going to be subject to taxation. However, the type of income will determine the specific tax treatment, and ultimately determine how much you get to keep.

We can break income down into three basic types: ordinary income, capital gains income, and interest income. Here’s a breakdown of each.

  • Ordinary Income – Ordinary income (OI) is income received that is subject to ordinary income tax rates. These tax rates are the rates individuals pay on incremental amounts of income. Rates can be as low as 10% and as high as 37%. Income typically subject to OI rates is income from your wages (W2, self-employment), taxable bond interest, taxable retirement income, and annuity income.
  • Capital Gains Income – Capital gains income occurs from the sale of assets such as stocks, bonds, mutual funds, ETFs, real estate*, and other assets. Depending on how long the assets were held determines if capital gains are taxed at OI rates or more favorable long-term rates. Assets held for one year or less and then sold, have any gain subject to OI rates. Asset held longer than one year and then sold have gains taxed at long term capital gains (LTCG) rates – which are either 0%, 15%, or 20% – depending on your total income. The higher your total income, the higher the LTCG rate you’ll pay. Qualified dividends from stocks are generally taxed at the favorable LTCG rates.
  • Interest Income – Interest income is income from assets that generate interest such as bonds, savings accounts, CDs, treasuries (savings bonds, T-bills, etc.), and money market accounts. In most cases this income is taxed at OI rates. One exception is interest from municipal bonds issued by city or state governments. Interest on these bonds is not taxable at the federal level and may avoid state and local taxation as well.

Knowing how specific income is taxed can help with the process of where to hold specific assets and in which accounts – called asset location (discussed later). This can improve your tax efficiency. Additionally, capital losses (selling an asset for less than you paid for it) may be used to offset other income, also improving tax efficiency.

These are the basics of income. Naturally, there are going to be exceptions and complexities that may apply to you. To avoid costly mistakes, you may benefit from the advice of a tax professional -usually a CPA who specializes in tax, an Enrolled Agent (EA – enrolled to represent taxpayers before the IRS), or a tax attorney. *Gains on the sale of your primary residence may not be taxed up to $250,000 for single and up to $500,000 for married tax filers. Specific rules app

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