2014 Year-End Planning: Investment Income

Qualified dividends are taxed at the favorable long-term capital gains tax rather than your higher, ordinary-income tax rate. Interest income is generally taxed at ordinary-income rates, which are now as high as 39.6%. So stocks that pay qualified dividends currently may be more attractive tax-wise than other income investments, such as CDs, money market accounts and bonds. But there are exceptions. Some dividends are subject to ordinary-income rates.

These may include certain dividends from:

  1. Real estate investment trusts (REITs),
  2. Regulated investment companies (RICs),
  3. Money market mutual funds, and
  4. Certain foreign investments.

The tax treatment of bond income varies. For example:

Interest on U.S. government bonds is taxable on federal returns but generally exempt on state and local returns.

Interest on state and local government bonds is excludible on federal returns. If the bonds were issued in your home state, interest also may be excludible on your state return.

Corporate bond interest is fully taxable for federal and state purposes.

Bonds (except U.S. savings bonds) with original issue discount (OID) build up “interest” as they rise toward maturity.

You’re generally considered to earn a portion of that interest annually — even though the bonds don’t pay this interest annually — and you must pay tax on it. (See the Case Study “The dangers of ‘phantom’ income.”)

Keep in mind that, although state and municipal bonds usually pay a lower interest rate, their rate of return may be higher than the after-tax rate of return for a taxable investment, depending on your tax rate. To compare apples to apples, calculate the tax-equivalent yield, which incorporates tax savings into the municipal bond’s yield. The formula is simple:

Tax-equivalent yield = actual yield / (1 - your marginal tax rate)

Warning: The NIIT also may apply to your dividend and interest income.