What Investment Income Is Taxed?To understand exactly how your investment income will be taxed, you will need to know some basic income definitions.
- Ordinary income is any income earned from a salary or wages, self-employment, interest, and short-term capital gains (income from selling assets held for 12 months or less).
- Investment income includes any distributions you receive from your investments, such as interest, dividends, and capital gains.
- Capital gains are the amount of money you make on an asset over your basis when it is sold. They are the difference between the amount you sell the asset for and the amount you paid for it. The basis is the amount you have invested in an asset; it includes your initial investment plus any additional investments for improvement. Long-term capital gains (on investments held longer than 12 months) are taxed at lower rates than ordinary income.
- Ordinary dividends are company profits paid to shareholders in the form of cash, stock, or property. Prior to 2003, they were taxed as ordinary income. In 2003 through 2010, they are taxed at lower rates. Capital gains dividends are distributions from a mutual fund or other entity that represent long-term profits from the sale of assets within the entity and are taxed at lower long-term capital gains rates.
- Taxable interest includes interest from bank accounts, loans you make to others, and from other investment sources such as US Treasury bonds.
- Passive activity income is income derived from a trade or business activity in which you didn't materially participate during the tax year. To "materially participate" means to be involved in the day-to-day operations of the activity on a regular basis. Rental activities are also a type of passive activity. You can only deduct passive activity losses from passive activity income. Active income is income from wages, tips, salaries, commissions, and a trade or business in which you materially participate.