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Will I have to pay tax on my investment income?

The taxation of your investment income depends on several factors, including the type of investment income you have (e.g., tax exempt, ordinary, capital gain, or tax deferred).

If you have municipal bonds, the interest they generate is typically exempt from federal taxation and state taxation in the state the bonds are issued. The interest may or may not be subject to state income tax in the state of your residence, if different from the state of issue. U.S. Treasury bills and certain types of government savings bonds generate interest that is typically subject to federal tax, but not state tax.

Of course, not all investments are tax exempt. Investment income is generated by either the income it produces during the ownership of the investment (e.g., interest, dividends, or rent) or the gain it produces when the investment is sold at an appreciated value. Investment income such as interest and rent is considered ordinary income and will generally be taxed according to your ordinary income tax rate. If you have investment income from the sale of a capital asset that is held for more than one year (e.g., stock or investment property), the income is generally considered capital gain and is taxed at long-term capital gains rates. Qualifying dividends are also taxed at long-term capital gains rates (dividends that don't qualify for long-term capital gains rates are taxed at ordinary income tax rates).

Finally, you should know that tax-deferred investments (such as 401(k) plans) produce earnings and gains that are not taxed until later, when the money is distributed to you.

For more information, consult a tax professional.

Note: Starting in 2013, a new 3.8 percent Medicare tax will also be imposed on interest, dividends, capital gains and other investment income for individuals making more than $200,000 ($250,000, if married filing jointly).