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Tax Implications of Investment Earnings

Besides knowing how investment earnings are paid out, it is important to know how your earnings will be taxed. Dividends are taxed at the lower capital gains rates: 15 percent for taxpayers in the 25 percent and higher brackets; for those in the 10 and 15 percent brackets, dividends are taxed at 5 percent for 2007, then at zero percent in 2008. In 2011 the lower rates are scheduled to "sunset" or expire, and the tax on dividends will revert to the prior ordinary income tax rates. The interest from most municipal bonds is exempt from federal, and sometimes state, income taxation.

Capital gains on investments held for more than a year are usually taxed at a lower rate than other forms of income.

Capital gains on investments that are held for more than a year (called long-term capital gains) are usually taxed at a lower rate than other forms of income. Capital gains are taxed at 15 percent for taxpayers in the 25 percent and higher brackets. For those in the 10 and 15 percent brackets, capital gains are taxed at 5 percent for 2007, and then at zero percent in 2008. Be aware, however, that this tax benefit applies only to capital gains transactions after May 5, 2003. In 2011, the lower rates are scheduled to "sunset" or expire.

Another important tax implication is centered on capital losses—the opposite of capital gains. If you lose money on your investments, you are able to deduct up to $3,000 of your losses in excess of any gains from your taxable ordinary income. Losses over $3,000 may be carried over to future years. This explains why so many people sell their stocks in December. Investors often choose to unload securities that are losing money in December in order to take advantage of this deduction on their income tax forms.