Investing in the market is definitely a long-term strategy. But even if you’re committed to the buy-and-hold philosophy, you’re ultimately in it for the income.
Even if you don’t plan to cash in on your investments for years, understanding the types of investment income available can help inform your investing strategies. And knowing how different types of investment income are taxed can help you determine which income to withdraw before others in the event that you need cash.
When you deposit funds into interest-bearing investments, such as CDs, bonds and money market accounts, you’ll earn interest income on those investments. Traditionally, investors who needed to cash out investment earnings could withdraw the interest without touching their investment principal. However, that’s not necessarily the case today.
“You used to be able to generate 5 percent in interest from bonds, CDs or other investments,” says Chris Cook, president and founder of Beacon Capital Management in Dayton, Ohio. “But today, interest rates are so low. It’s difficult to generate consistent, reliable income from interest and dividends.”
When you do withdraw interest income—whether from cash, CDs or taxable bonds—it’s taxed at your ordinary income tax rate. Also, be aware that if you have a long-term CD or bond, you still need to report the annual interest you earn each year to the IRS, even if you don’t cash it out that year.
Some companies pay dividends, or regular payments based on their earnings, to stockholders or investors. Dividends are paid per share of stock; for instance, if you own 10 shares in a company and that company pays $3 in annual dividends, you’ll earn $30 per year ($3 multiplied by 10 shares). If you invest in a mutual fund that owns shares in dividend stocks, you’ll typically earn a share of those dividends on a quarterly or annual basis, depending on the company.
Just like other types of income, you have to pay taxes on the dividends you earn. Ordinary dividends are taxed the same as your regular income tax rate, but those that meet certain requirements and are labeled “qualified” dividends are taxed at the capital gains rate, which is usually lower. (Acorns automatically reinvests your dividends for you to help your money grow faster. Find out more.)
A capital gain is a rise in the value of an asset, such as an investment in stock or real estate, that makes it worth more than the purchase price. The gain is realized when the asset is sold. For example, let’s say you invest $100, buying 10 shares of a stock priced at $10. Over the next two years, the stock price goes up to $13 a share, and you decide to sell all 10 of your shares. Your capital gain is $30—or $130 (10 shares at $13 a share) minus the $100 you paid for those 10 shares initially.
When you sell an investment at a gain, you have to pay capital gains taxes. In 2019, the capital gains tax rate for assets held longer than one year is 0 percent, 15 percent or 20 percent, depending on your tax bracket. If you earn income on an asset held for less than a year (a “short-term capital gain”), that income is taxed at your normal tax rate.
“The rates for long-term capital gains are substantially less than ordinary income tax rates,” says Stein Olavsrud, CFP, executive vice president and portfolio manager at FBB Capital Partners, headquartered in Bethesda, Md. “Therefore, it is preferable, where possible, to benefit from long-term capital gains as opposed to ordinary income tax rates or short-term capital gains rates.”
In other words, holding onto an investment for more than one year can often cut the taxes you’ll pay on any gains.
When you buy a bond, you’re essentially loaning money to the issuer for a predetermined amount of time. You can earn money on bonds by holding them until their maturity date and collecting interest payments, usually paid twice a year, in the meantime. You can also profit by selling bonds at a price that’s higher than your initial purchase price.
“Currently, bond yields remain very low,” says Ryan Giannotto, director of research at GraniteShares, an ETF issuer based in New York, N.Y. He notes that Bloomberg Barclays Aggregate Bond Index, the standard benchmark for broad-based bond returns in the United States, only yields 2.6 percent. “At many income levels, investors may not even be keeping up with inflation after taxes.”
High-rated bonds are earning very little, but lower quality bonds—sometimes called “junk bonds”—can offer higher returns. Those higher returns are accompanied by greater risk, though, says Cook. Bond funds, which may include some high-rated bonds and some junk bonds, “allow you to diversify the holdings and can generate reasonable income,” he adds.
Unlike individual bonds, bond funds are ongoing investments without specific maturity dates. For both individual bonds and bond funds, investors should only anticipate total returns between 2 and 4 percent currently, says Tim Sullivan, CEO of Strategic Wealth Advisors Group in Shelby Township, Mich.
There’s no hard and fast rule that works for everyone. The investment income that works best for you will depend on your specific income tax bracket and whether your investment account is taxable or tax-deferred (like an Individual Retirement Account), Olavsrud says.
If your investment account is taxable, there are particular investments, or types of income, that are more favorable from a tax perspective than others. “Long-term capital gains and qualified dividends will be more beneficial than short-term capital gains, non-qualified dividends and interest,” Olavsrud says.
Start by determining your objectives and then figure out the tax structure associated with any new investment. “There are numerous strategies from tax-deferral, tax-exempt bonds, long-term capital gains, qualified dividends, REITs and Master Limited Partnerships that may play a role in a portfolio,” Olavsrud says. “Often, it is not one singular strategy but a combination of multiple strategies weighted appropriately that can meet your objectives.”
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