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Investment income is any money received from an investment, including interest payments, dividends, capital gains and other profits.
According to the Internal Revenue Service (IRS), investment income includes interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are considered passive activities, such as a silent partner stake in a company.
“Investment income is an important source of income for many Americans, especially retirees who need cash flow to support themselves when they’re no longer working,” says James Royal, principal investing writer at Bankrate. “Plus, investment income may often be taxed at more favorable rates than earned income, making it vital to understand for those wanting to build wealth.”
We’ll explore a few examples and outline the key tax implications you’ll want to consider.
Examples of investment income
Investment income is commonly found in brokerage accounts and interest-earning savings accounts. While retirement accounts such as IRAs and 401(k)s may earn investment income, this income is not taxed when it is paid. Instead, you are taxed on the money withdrawn from the account during retirement and this income is reported on a separate part of your tax return.
Some of the most popular investment vehicles that generate investment income include:
- Stocks
- Bonds
- Investment funds, such as mutual funds or ETFs and other securities
- Certificates of deposit (CDs)
- Real estate
- Annuities
- The investment portion of life insurance contracts
- Interests in trusts and estates
- Collectible items
- Commercial crops
- Accounts or other funds receivable and businesses
How is investment income taxed?
Your investments simply increasing in value aren’t considered taxable income unless you sell and receive a profit. Once you realize a gain on an asset, the IRS considers that investment income.
How investment income is taxed depends on a number of factors, including the holding period, your total income and the type of investment income received. To note: Withdrawals from a traditional 401(k) or traditional IRA are taxed as ordinary income, not capital gains. Withdrawals may be subject to penalties if you’re younger than 59 1/2 years old.
Net Investment Income Tax (NIIT)
Certain investment income may be subject to the Net Investment Income Tax (NIIT). This surtax applies to individuals with a modified adjusted gross income (MAGI) above certain income thresholds ($250,000 for married filing jointly, $200,000 for single filers) and to certain estates and trusts. Taxpayers may owe the NIIT if their MAGI exceeds the statutory threshold for their filing status. The NIIT amount is 3.8 percent of the lesser of the Net Investment Income (NII) or the excess of MAGI over the threshold amount. Wages, self-employment income, Social Security benefits and distributions from some qualified retirement plans are not subject to the NIIT. You can learn more about the NIIT on the IRS website.
Investment income that may be subject to the NIIT includes:
- Interest
- Dividends
- Capital gains
- Rental and royalty income
- Non-qualified annuities
- Income from businesses involved in trading of financial instruments
- Commodities and businesses that are passive activities to the taxpayer
Capital gains and qualified dividends
Most types of investment income are taxed at ordinary income tax rates. For example, when you sell an asset you’ve had for less than a year for profit, that’s considered a short-term capital gain and is taxed at your ordinary income tax rate, which can range from 10 percent to 37 percent.
However, capital gains from selling assets that were held for more than a year are usually taxed at lower long-term capital gains tax rates, which range from 0 percent to 20 percent. Qualified dividends, which are eligible for the same favorable tax rates as long-term capital gains, are usually paid by companies on their common stock.
Interest and ordinary dividends
Interest income may be exempt from federal tax if it’s generated by municipal bonds, but it’s not exempt from other potential taxes, such as the NIIT. Interest income is generally taxed at ordinary income rates. Ordinary dividends, unlike qualified dividends, may also be taxed at ordinary income tax rates. Ordinary dividends are most commonly paid by real estate investment trusts (REITs) and master limited partnerships (MLPs).
Rental income and home sales
Rental income is considered investment income and is taxed accordingly. In certain cases, it could be considered business income and therefore receive qualified business income tax treatment. It’s best to check with the IRS and your accountant to be certain.
If you sell your principal residence (your home), the IRS may exempt the first $250,000 ($500,000 in the case of a married couple) of gain recognized on the sale from gross income for regular income tax purposes. This amount would therefore be exempted from the NIIT. For the exemption to apply, you must have used the home as your main residence for a cumulative, but not necessarily consecutive, two years out of the last five years prior to selling it.
What is income investing?
Switching word order here makes a difference — income investing isn’t the same thing as investing income.
Income investing is the practice of building a portfolio with assets that generate cash on a recurring basis. Income investors want to maximize the amount of cash they receive and, as a result, usually choose to invest in assets that pay dividends, interest or rent on a regular basis. These types of investments form the stable foundation of a portfolio.
Common stock dividends are usually lower than preferred stock dividends, but common stock offers the prospect of unlimited capital gains. However, common stock is riskier because the price can fluctuate more than preferred stock, and is often a total loss in the event of bankruptcy because it is last on the list of claimholders.
Some common income investing asset examples include:
- Dividend-paying stocks
- Bonds
- Real estate
- Money market funds
- Certificates of deposits
- Money market accounts
- Annuities
Bottom line
Investment income is the money you make from your investments, including common accounts, such as interest-earning savings accounts and brokerage accounts. While investment income is a great way to build wealth, keep in mind that some investments can complicate your taxes. If you find yourself lost come tax season, be sure to consult a tax professional. Even better, you might consider hiring a financial planner before you start investing.
