Written by We all love the idea of passive income—money flowing into our accounts while we sleep or lounge on the beach. But unfortunately, the taxman never sleeps, and he’ll want his share of that sweet, sweet passive income. Let’s break down the basics of how your dividends and interest income are taxed.
Dividends and How They’re Taxed
Example: Let’s meet Lisa. Lisa invested in several dividend-paying stocks. Every quarter, she gets a nice payout from those companies as a thank-you for holding their stock. But what Lisa didn’t initially know is that not all dividends are taxed the same way. You’ve got qualified dividends and ordinary dividends.
- Qualified Dividends: These are taxed at a more favorable rate, similar to long-term capital gains. This rate depends on your income bracket, but for most people, it ranges from 0% to 20%. Nice, right?
- Ordinary Dividends: These are taxed at your ordinary income tax rate, which can go up to 37% depending on your income. Ouch.
Now, Lisa’s investment strategy has become a little more tax-savvy. She makes sure to hold her dividend-paying stocks for the required period so that more of her dividends qualify for the lower tax rate.
Interest Income
If you’ve got money in a savings account, CDs, or bonds, then you’re earning interest income. Unlike dividends, all interest income is taxed as ordinary income. That means whether you’re earning interest from your bank account or from a bond, Uncle Sam wants his cut, and he’s not giving you the “qualified” dividend treatment here.
Example: Let’s say Mike has a $10,000 CD earning 2% interest annually. At the end of the year, Mike earns $200 in interest. He has to report this as ordinary income on his tax return, which means it’s taxed at his marginal tax rate.
Pros and Cons
Pros:
- Dividends: Great for generating regular income without selling your investments. You can reinvest them or spend them as you like.
- Interest: Reliable and steady income, especially if you invest in bonds or other fixed-income products.
Cons:
- Dividends: If they aren’t “qualified,” you might be hit with a higher tax rate. Also, high-dividend-paying stocks aren’t always the best performers in terms of growth.
- Interest: Taxed at the ordinary rate, so for high-income earners, this could mean forking over a sizable portion of your earnings to the IRS.
Pro Tip: To minimize the sting of taxes on interest income, consider stashing your bonds or high-interest savings in tax-advantaged accounts like a Roth IRA. It’s the investment equivalent of a comfy tax-free bubble.