Taxation of Investment Income
About This Lesson
Investment taxation is its own small world on the SIE, and the good news is that it rewards pattern recognition over arithmetic. You will not compute anyone's tax bill. Instead, the exam hands you a type of income, or a holding period, or a transaction, and asks how it is taxed. Learn to sort income into a few categories and apply two or three bright-line rules, and the questions become almost mechanical.
What you'll cover
- how interest and dividends are taxed, including the municipal-bond exception
- capital gains and losses, the one-year line, and cost basis
- the wash sale rule
- the tax treatment of mutual funds, ETFs, annuities, 529 plans, and options
This is the final chapter of the products module.
Interest & Dividend Income
You will not have to calculate a tax bill on the SIE, but you do need to know which kinds of investment income are taxed lightly and which are taxed at the highest rates, because that difference drives many suitability questions. Almost all investment income falls into one of three buckets:
- Ordinary income, taxed at the investor's regular (highest) rate, the default for interest and short-term gains.
- Capital gains and qualified dividends, taxed at preferential rates when the holding requirements are met.
- Tax-exempt income, escaping federal tax entirely, the province of municipal bonds.
Almost everything that follows is a matter of sorting one kind of income into the right bucket.
Interest from most debt is taxed as ordinary income at the investor's marginal rate. That covers:
- corporate bonds
- U.S. Treasury securities, which are taxable at the federal level but exempt from state and local tax
- certificates of deposit and money market instruments
The municipal bond exception
Interest from municipal bonds is generally exempt from federal income tax, and if the investor lives in the issuing state, it may be exempt from state and local tax too, the prized "triple tax-free" combination. Because of that break, munis carry lower coupons than comparable corporate bonds, so to compare them fairly investors convert to a tax-equivalent yield:
Tax-Equivalent Yield = Muni Yield ÷ (1 − Tax Rate)
For example, a muni yielding 3% for an investor in the 30% bracket has a tax-equivalent yield of 3% ÷ 0.70 = 4.29%: the investor would need a corporate bond yielding at least that much to come out even after tax.
Corporate bond interest → Ordinary income (fully taxable)
Treasury bond interest → Federal tax yes, state/local tax NO
Municipal bond interest → Federal tax NO (usually), may be triple tax-free
This hierarchy is one of the most tested tax concepts on the SIE.
Dividends are distributions of corporate profit, and how they are taxed turns on whether they are qualified or nonqualified.
Qualified dividends
Paid by U.S. (or qualifying foreign) corporations on stock held for more than a 60-day minimum, qualified dividends get the lower long-term capital gains rates of 0%, 15%, or 20%.
Nonqualified (ordinary) dividends
Dividends that miss the holding-period or other tests are taxed at ordinary income rates. REIT dividends are generally ordinary.
Other distributions
- Return of capital is not taxed when received; instead it reduces cost basis, deferring tax until the shares are sold.
- Stock dividends are generally not taxable when received; the existing cost basis is simply spread across the new, larger share count.
Interest income from municipal bonds is generally:
Capital Gains, Losses & the Wash Sale Rule
A capital gain is selling an investment for more than you paid; a capital loss is selling for less. The holding period decides the rate.
Short-term vs. long-term
- Short-term (held one year or less) is taxed at ordinary income rates, with no break.
- Long-term (held more than one year) gets the preferential 0%, 15%, or 20% rates.
Cost basis
Cost basis is what you paid, including commissions, and it sets the gain or loss at sale. Investors can choose which shares are treated as sold using:
- FIFO (first in, first out), the default, which assumes the oldest shares go first
- Specific identification, naming the exact shares to sell
- Average cost, used for mutual fund shares (total cost ÷ total shares)
Capital loss rules
- capital losses offset capital gains first
- up to $3,000 of net capital loss can then be deducted against ordinary income each year
- any unused loss carries forward to future years
An investor sells stock held for 8 months at a profit. How is this gain taxed?
An investor sells 100 shares of XYZ stock at a loss and buys back 100 shares of XYZ 15 days later. Under the wash sale rule:
Tax Treatment by Product
A handful of products carry tax rules worth memorizing outright:
- Mutual funds must distribute their capital gains and dividends to shareholders each year, who owe tax on those distributions even if they are reinvested.
- ETFs are generally more tax-efficient, because the in-kind creation and redemption process minimizes capital gains distributions.
- Variable annuities grow tax-deferred, but withdrawals are taxed as ordinary income (no capital gains treatment), with a 10% penalty before age 59½.
- 529 plans grow tax-free when used for qualified education expenses; on a non-qualified withdrawal, the earnings are taxed as ordinary income plus a 10% penalty.
- Options premiums: when an option expires worthless, the premium is a capital loss for the buyer and a capital gain for the writer, short-term regardless of how long the position was open.
Chapter Essentials
Tax questions come down to sorting income into three buckets. Interest from corporate bonds, Treasuries, and CDs is ordinary income (Treasuries are exempt from state tax; municipal interest is federally tax-exempt, sometimes triple tax-free). Qualified dividends and long-term capital gains (assets held more than a year) get the preferential 0/15/20% rates, while nonqualified dividends and short-term gains (held a year or less) are taxed as ordinary income.
Two rules carry extra weight. The wash sale rule disallows a loss if you rebuy the same or a substantially identical security within 30 days before or after the sale, rolling the disallowed loss into the new shares' basis. And on product taxation, mutual funds pass through annual taxable distributions, ETFs avoid most of them, and variable-annuity withdrawals are always ordinary income.
The reliable gotchas in this chapter:
• One year or less is short-term. A gain on an asset held a year or less is taxed at ordinary rates, with no preferential treatment. You need more than a year for long-term rates, so eight months is short-term.
• Munis are federally exempt, not always state-exempt. Municipal interest escapes federal tax; it is state-exempt only when the investor lives in the issuing state. Treasuries are the reverse, federally taxable but state-exempt.
• Thirty days, before or after. The wash sale window runs 30 days on each side of the sale, a 61-day span. Rebuying a substantially identical security inside it disallows the loss, which then attaches to the new shares' basis.
• Qualified dividends need a holding period. Only dividends meeting the more-than-60-day rule get capital gains rates. REIT dividends do not qualify and are taxed as ordinary income.
• Return of capital is not a dividend. It is not taxed when received; it lowers your cost basis and defers the tax until you sell.
• For a high-bracket investor seeking tax-advantaged income, think munis. Tax-free interest is worth most to those in the highest brackets, which is exactly what the tax-equivalent yield captures.