Ep 65: What Is English For "Investment Income"?
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There are three types of investment income: interest, dividends, and capital gains. Do you know how each is generated, reported, and taxed?
You are in luck – we cover all this and more, emphasizing the importance of understanding these concepts for effective financial planning.
We also explain the implications of being a tax resident versus a non-resident, as well as the potential for additional taxes, such as the net investment income tax.
Chapters
00:00 Understanding Investment Income: Interest, Dividends, and Capital Gains
10:55 Tax Implications of Investment Income
11:55 Conclusion and Resources
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Jane Mepham, CFP (00:02.132)
Wait, I have to report interest, dividends and capital gains on my taxes?
Jane Mepham, CFP (00:11.598)
Today's shortie is about all the differences between interest dividends and capital gains.
This was prompted by a conversation I had with a prospect recently who was surprised when they realized they haven't been reporting this on their returns.
And so in today's conversation, Manasa and I are going to walk you through the three types of investment income: interest, dividends, and capital gains.
And tell you exactly what IRS expects you to do with them. Okay, Manasa, where do you want to go with this?
Interest Income
Manasa Nadig, EA (00:46.852)
I am going to go with the top one really, which everybody's talking about these days, right? It's interest. And your interest earnings could come from your bank accounts, savings accounts, your CDs, fixed deposits, and all that good stuff, as well as cash held in other places like your brokerage accounts and your other investment accounts.
Basically, if you can think of it as money you have lent to another organization, which is holding and using it, and they pay you for it, that is nothing but bank interest. Unfortunately, there isn't much control you have over this other than deciding where this money can go and what different rates of interest are offered on these different accounts.
It hits your account at a particular cadence, maybe monthly, quarterly, or annually. And the taxation of bank interest is taxed at the ordinary income tax rate.
So whatever income tax bracket you fall into, that's the income tax rate for the bank interest.
Reporting Interest – Are You A Tax Resident Or Not?
Now, speaking of taxation, the reporting of your bank interest depends on whether you are a U.S. tax resident or a non-resident individual. So if you are a non-resident individual, then
the institution where you have the money understands that and then they give you a form 1042 S.
But if you were a tax resident of the U.S., then this money is reported to you on Form 1099, and that is then reported on Schedule B, and then that flows through to your Form 1040. So, you know, it's going similarly, keeping up with the topic of taxation. I know that we'll go into it more with the other types of interest, but just quickly over here.
Manasa Nadig, EA (03:14.359)
There are also dividends and capital gains. Now, dividends are reported to a tax resident on a 1099-DIV for dividends. And then they are reported on Schedule B on Form 1040. And capital gains usually come from a brokerage statement called the 1099-B as in brokerage. And it is reported on Schedule D of your Form 1040.
Non-resident individuals get all this information on a Form 1042S. So, taxation is a little different. The rules are different for non-resident individuals. And it depends on various other factors. The payor may withhold taxes at source on these payments to a non-resident individual.
But there are ways of mitigating that by filing the form W8 BEN. There are various different types of W8, BEN, depending on the type of individual or a business or how you're holding these accounts. So that's a bit about interest as well as I snuck the taxation part in there, Jane, what do you say?
Jane Mepham, CFP (04:35.727)
Well, what I love about our conversation is that every time we talk, some of these things, you have to be thinking about the taxation aspect. So, it's fantastic and that's why I love doing some of this with you.
So Manasa's already told you how capital gains are taxed, but let me give you a little bit more about capital gains. So capital gains, think of it as
Capital Gains
Jane Mepham, CFP (05:00.43)
growth in your brokerage account. You're holding stocks, shares, ETFs, and mutual funds. You buy a mutual fund, it goes from let's say $10 to $20. That $10 is your capital gains. Now the most significant difference, and this is where we have control, is that it can be what's called realized or unrealized.
Now unrealized gains is when it goes from $10 to $20. You leave it in the market, you haven't sold. We just leave it alone. That's unrealized capital gains. And there's nothing you have to do about it. You just have to let it keep growing.
Now, realized gain is when you actually sell it. So let's say, again, you have this fund that's gone from $10 to $20. You sell it. Now, your capital gains, realized capital gains is going to be the $10. And the main difference between
When it comes to taxation, which Manasa has already told you what form this will get reported on is how it's taxed. It can be taxed at long-term or short-term rates. So, the short-term rate is basically your ordinary income tax rate.
Long-term, which is more favorable, can actually be 0, 15 or 20 % based on your income. And the key thing is you have to hold this asset for more than a year. If you hold it for more than a year, then you end up getting the long-term gains.
But one thing I do want to call out, because this is all reality and it's something we deal with all the time, if you're, let's say, a US resident, tax resident living overseas, and your country considers tax rates the taxation differently, long term versus short term. It's something you just want to be careful about.
We've had cases, for example, maybe let's use India as an example, they consider overseas assets, anything held less than two years to be short-term. So that's just something you want to be careful about, because again, we see it all the time.
And I think I'm not going to add any more to the capital gains. Manasa, do you want to talk about dividends?
Dividends
Manasa Nadig, EA (07:28.513)
Yeah, definitely. Definitely going off of what Jane said, there are many aspects of this which apply especially in the cross-border context. going off of that, there are dividends.
So, what are dividends? Dividends are really payments made by a company to their shareholders for the stock that is held in their company.
So it really depends on how much shares and how much stock you hold and based off that you may be able to earn dividends. Now you may have chosen to have these dividends paid out to you or you may have chosen to have them reinvested back into the account.
But no matter what unlike the unrealized and realized capital gains and not to confuse that issue.
But here, just briefly, if you have decided to reinvest those dividends or getting them paid, it doesn't matter. The dividends are going to be taxed. The difference, though, is between qualified dividends and non-qualified dividends. Okay, so I know that's a lot of information. So in summary
Qualified Dividends Non-Qualified Dividends
Qualified dividends are dividends that the corporation pays to you and this is dependent on very specific criteria, which is established by the Internal Revenue Service and the corporation knows that information as when they're paying it out as to what part of the dividends you're getting are qualified and what part of the dividends you're getting are non-qualified.
So depending on whether dividends are qualified or non-qualified, that determines what the tax rate on those are. So, if you have non-qualified dividends, those are all subject to ordinary income tax rates. So, whatever the income tax bracket is you're in for the rest of your income.
Manasa Nadig, EA (09:52.13)
Now qualified dividends are subject to a lower tax rate. So that's a good planning strategy as far as the tax treatment goes. If you are a non-resident individual, you file this information on a 1040 NR, and you may end up paying 30% tax depending on the tax treaty between you and the country. It’s the tax treaty between the US and the country where you live.
So that's the part about dividends. And I don't think that there is much else to say really about dividends, right, Jane?
Jane Mepham, CFP (10:37.798)
Yeah, I think I love what you said about the tax planning opportunity, which is some things we'll do with our prospects and clients. We can help you figure out, you know, what mutual funds, what assets to invest in that give you more qualified dividends than the non-
qualified dividends. But it's all good. think what you've said. The only other thing I'll say overall is now based on your income, your interest, your capital gains, your dividends,
Net Investment Income – 3.8%
You could end up paying an extra tax on net investment income of 3.8%. And we've done a whole episode on that. We're going to link it to the show notes on this. But I think that's it. Anything else you want to add or should we conclude, Manasa?
Manasa Nadig, EA (11:25.339)
Yeah, it's always good to remember that one that sneaks by the net investment income tax of 3.8%. So, depending, like Jane said, on other things, remember you might be subject to that additional tax rate. So yeah, let's conclude, Jane. This was a quick dive into the Waters of investment income.
And I hope, dear listener, that you had a good takeaway today on what this is and how it needs to be reported. Thank you for being here, and thank you for listening. Please go to our website, theimcafe.com, and look at all our downloads. We have quite a few of them now. We have our freebies.
And we have a few premium downloads as well. And I'm sure that once you look at those, you will find that they are amazing and very useful and step-by-step planning opportunities and checklists. So, please go grab those downloads. And thank you for listening today. Bye until next time.
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The speakers' views and opinions discussed in this episode should not be considered financial, tax, or legal advice. Consult your advisor for any legal, cross-border tax, and financial advice.