Interest Income…..That is a topic that over the past few years nobody has given much thought too. You could have big account balance in the bank and basically get pennies on your savings. That has all changed due to the Federal Reserve raising interest rates this past year. Savings and CDs rates are actually something you can brag about at the neighborhood barbecue.
Now comes the taxing part. While you may be earning more interest, you will more than likely have to pay income tax on that interest income and dividends that you have been receiving. If your bank pays you more than $10 in interest you will receive a 1099 at the end of the year. Let’s review the various types of income/dividends and how they are taxed:
- Taxable Interest Income: Most interest income is considered taxable at the federal level. This includes interest earned from regular savings accounts, CDs, and taxable bonds. Taxable interest is subject to ordinary income tax rates, which vary based on an individual's income bracket.
- Tax-Exempt Interest Income: Certain types of interest income are exempt from federal income tax. Municipal bond interest is a prime example. Interest earned from qualified municipal bonds is typically tax-exempt at the federal level and may also be exempt from state and local taxes, depending on the issuer and the taxpayer's residency.
- Qualified Dividends: Qualified dividends are subject to lower tax rates than ordinary income. To qualify for this favorable tax treatment, the dividends must meet specific requirements, such as being paid by a U.S. corporation or a qualified foreign corporation. The tax rates applicable to qualified dividends are based on the capital gains tax rate which can be 15% or 20% depending on your income.
- Non-Qualified Dividends: Non-qualified dividends do not meet the requirements for preferential tax treatment and are taxed at the individual's ordinary income tax rates. Non-qualified dividends include dividends from real estate investment trusts (REITs), dividends on employee stock options, and certain dividends received in tax-advantaged accounts.
Strategies for Maximizing After-Tax Returns
To optimize after-tax returns from interest income and dividends, individuals can use a strategy of asset location. Invest in taxable bonds or high dividend paying stocks in a IRA while using municipal bonds and growth stocks in a taxable account.
Two last items:
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