Dividends, Interest, and Capital Gains on Personal Income Taxes

Individual income subject to income taxes can come from a variety of sources. The majority of a person’s salary, wages, and tips come from employment. Consequently, most income is conveniently reported to employees on their annual W-2 form which organizations are required to supply to employees in a timely manner after the close of the tax year. Some income such as tips is not included on a W-2 form and must be recorded and reported by the individual earner.

When an individual owns shares of stock in a company, the company may decide to pay quarterly dividends to stockholders. These dividends are taxable because they are classified as income for the holder of the stocks. Both common and preferred stockholders are subject to taxes on any dividends paid through the year.

Interest income received by companies and individuals is fully taxable under U.S. tax laws. This is why an analysis of the amount of interest to charge on a loan must include an estimate of the taxes the creditor will expect to pay. Interest rates must, therefore, not only represent the amount of risk associated with lending money, it also must be able to cover any expenses including taxes due when interest income is received. Interestingly, for constitutional purposes and under most circumstances, interest income from state and local government is not taxable by the Federal Government. The tax-free nature of municipal bonds can be an attractive investment.

One of the most attractive features of owning long-term securities (assets held for more than one year) is the tax-timing option created when the value of a long-term asset increases. Suppose an individual buys 1,000 shares of common stock in a major corporation currently trading at $10 per share. At the end of two years, the stock has risen to $12 per share. The investor has gained $2 for every share owned. However, the investor is not required to pay taxes on this capital gain until the shares of stock are sold and the income is realized. This is the nature of the tax-timing option. Essentially, it is the option to delay paying taxes on a capital gain until income is realized in the form of an actual cash flow. Losses can even be used to reduce taxable income when a loss is realized.

Dividends, interest, and capital gains all represent taxable income that must be reported to the Federal Government. Often, individuals filing for a given period have only one source of income, employment, in which the employer supplies the employee with a W-2 summarizing all salaries and wages earned in a given year. Investments require the tax payer to properly record any extra income not found on a W-2 to avoid non-compliance with Federal tax laws.

As always, consult a profession tax preparer to determine the best method for determining your taxable income.