Have you heard the term "investment income"? Do you know what it means? If you're an American citizen who has money in an interest-earning bank account, mutual fund, or stock, you need to know about your personal investment income and whether it's taxable. If it is, you'll have to calculate the appropriate tax rate and include it in your taxable income for the year. Since tax rates for investment income can fluctuate, understanding how different types of investment earnings are calculated is critical to complying with IRS regulations. 

What is Investment Income?

Commonly referred to as "passive income," investment income is the money received on a financial account or holding. Unlike earned income such as wages or tips, investment income is generated without much physical work. In most cases, this income results from selling stocks or other passive assets. For taxpayers who receive gains through earning interest, little to no effort is required at all.

How the IRS Views Investment Income

According to the IRS, investment income can be categorized in two ways: ordinary or capital. Ordinary investment income includes any investment that earns interest, such as bank accounts, mutual funds, money market accounts, and shares of stock. For example, if you own a certificate of deposit that returns a three percent interest rate in 12 months, that three percent interest would be classified as ordinary income. Ordinary investment income is included in adjusted gross income and taxed at the ordinary tax rate.

Capital income, though, refers to income that is received through the sale of an investment asset such as a mutual fund or stocks. As an example, if you sell several shares of stock at a gain, your profits would be considered capital gain. Capital gains are taxed at a lower rate than ordinary income. If your sale results in a loss, you'll report a capital loss.

Dividends may be either ordinary income or capital gains. As a general rule, if the dividends are paid by a domestic or qualified foreign corporation, then they'll be taxed as long-term capital gains.

Reporting Tax on Investment Income

How you report your investment income tax depends on the type of income into which it falls. If your investment income is classified as ordinary income, you can lump it in with your gross income and pay your normal tax rate. If your investment income is a capital gain, you'll need to find the basis by adding your initial cost and the value of any increases or improvements to the asset. Afterward, you'll subtract the basis from the sale price to find your capital gain amount.

What if your sale results in a loss? You can calculate your capital loss by deducting the sale price from your basis in the asset. On your return, you can use the capital loss to offset any capital gains. Since the IRS restricts the amount of capital losses you can claim in one year, you can use any remaining loss amount by carrying it forward for use in later years. You can also carry the loss back up to three years by amending past returns.

If you receive income from any investment at all, you need to know how to plan your taxes to know how much of your investment income is taxable. With these tips, you can make sure you're in compliance with the federal government and don't face tax issues with the IRS.