Financial paper charts and graphs on the table-Aug-30-2020-11-18-38-42-AM


What Is Classification of Earnings and Losses?

Investment income is subject to either ordinary income tax rates or long-term capital gains tax rates (short-term capital gains are taxed at ordinary income tax rates). To understand how your investment income affects your income tax liability, you first need to classify your investment income as subject to either ordinary income tax rates or long-term capital gains tax rates. You also need to understand how your expenses and losses reduce your taxable income. Certain investment losses and expenses receive more favorable tax treatment than others.

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

Ordinary Income

Interest and some types of dividends are two types of income produced by investment assets that are generally treated as ordinary income.

Dividend Income Receiving Capital Gains Tax Treatment

Qualifying dividends paid to individual shareholders from domestic corporations (and qualified foreign corporations) are taxed at long-term capital gains tax rates.

Capital Gain

Capital gain generally represents the profit generated by the sale of an investment asset. Capital gain is taxed differently depending on how long you owned or held the asset. Short-term capital gains (assets held for one year or less) are taxed at ordinary income tax rates. Long-term capital gains (assets held for more than one year) are taxed at more favorable tax rates. In order to calculate capital gain or loss from the sale or disposition of an asset, you need to understand the tax basis rules.


The classification and existence of investment losses and expenses can have an impact on both your ordinary and capital gain items. Some losses are not allowed in the year in which they are incurred, but instead must be deferred. Special rules address your investment expenses while other rules impact your ability to utilize losses from passive activities.

How Do Your Investments Earn Ordinary Income?

If you invest in marketable securities (e.g., money market mutual funds or bonds), you may earn ordinary income if the securities pay dividends or interest. If your investment is in tangible property, however, your ordinary income generally consists of the stream of income resulting from the productive use of that property. For instance, if you own a building, the rental income from the building is treated as ordinary income.

Caution: If you invest in a pass-through business entity, like a partnership, you are treated as receiving a share of the business's items for income tax purposes. To the extent that your share of the business's items includes ordinary income, that income is treated as ordinary income on your return. You generally report income from pass-through entities as it is earned, regardless of whether you actually receive distributions from the entity.

How Is Ordinary Income Taxed?

The tax rate applicable to ordinary income depends on your filing status and the amount of money you earned during the year. Your taxable ordinary income is generally your net ordinary income (ordinary income reduced by ordinary deductions or losses). Currently, the top marginal tax rate is 37 percent, while the top long-term capital gains tax rate is 20 percent (in most cases) — a difference of 17 percent.

So, ordinary income is generally treated less favorably than long-term capital gains for federal income tax purposes, right? You can generally start with that assumption, but there are a number of tax and nontax reasons why you might actually prefer some amount of ordinary income. A classic nontax reason is that the investor needs steady current income to pay living expenses.

A good tax reason to generate ordinary income is that an investor has unused ordinary losses that can offset the income. In that case, the ordinary income would be sheltered by the unused losses. So, in some situations, recognizing ordinary income rather than long-term capital gains could actually reduce your tax bill.

How Do Your Investments Produce Dividends That Are Eligible for Capital Gains Tax Rates?

Dividends that qualify for capital gains tax treatment are paid by domestic and qualified foreign corporations and are received by individual shareholders. Dividends are distributions of property (including money) by a corporation to its shareholders that are made out of current or accumulated earnings and profits. Taxpayers may receive such dividends directly from the corporation or through a pass-through entity such as a mutual fund, regulated investment company, or real estate investment trust. Many special rules and exclusions apply.

Caution: Capital losses cannot be used to offset dividend income taxed at long-term capital gains tax rates.

How Do Your Investments Produce Capital Gains?

Capital gain refers to the profit you earn from the sale or other disposition of a capital asset. Capital gain is generated when the sale price for a capital asset exceeds your adjusted tax basis in that asset. Generally, your adjusted tax basis in an asset equals the price you paid for the asset with some adjustments. However, different basis rules may apply to assets acquired through gift or inheritance.

How Are Capital Gains Taxed?

Taxation of capital gains depends on how long you owned or held your investments (i.e., the holding period) before selling them. Assets held for one year or less generate short-term gains, taxed at ordinary income tax rates. If you held the investment for over a year, the gain is treated as a long-term capital gain. The applicable long-term capital gains tax rate is determined by the type of asset and your taxable income. Long-term capital gains are generally taxed at special capital gains tax rates of 0 percent, 15 percent, and 20 percent depending on your taxable income.

Caution: Short-term capital gain is not the same thing as ordinary income. The distinction is important when you are netting (offsetting) gains and losses.

Retirekit CTA

How Are Losses and Investment Expenses Classified?

Losses and expenses can be broken down into a few areas:

Expenses Incurred to Buy and Sell Investments

There are three types of investment expenses that you should consider: (1) commissions and other charges directly related to the purchase or sale of an investment, (2) interest expenses related to the purchase of an investment (this is often interest charged on a margin account, but it also covers debt incurred to purchase other investment assets), and (3) incidental expenses that pertain to your investments generally.

  • Commissions, fees, and charges paid to acquire or sell shares of common stock are not deductible. Rather, these costs are added to the tax basis of the shares. This either decreases your capital gains or increases your capital losses if and when you sell or otherwise dispose of the shares. These costs cannot be used to offset ordinary income.
  • Interest expenses incurred in connection with investment activities are generally deductible to the extent of net investment income. For instance, margin trading involves borrowing money from your brokerage house in order to purchase a security. Interest charged on a margin account is deductible but only when the interest is paid and only to the extent of net investment income.

Capital Losses

If you have capital losses in excess of capital gains, you have a net capital loss. If you have a net capital loss, you may offset only a limited amount against ordinary income. The remainder must be carried forward to offset capital gains (or a limited amount of ordinary income) in future tax years.

Pass-Through Losses

When you invest in pass-through entities, you report your share of the business's income, deduction, gain, and loss on your own income tax return. Generally, you can offset other income against any losses passed-through from the entity. However, there are a number of rules that limit your ability to do this. For instance, you have to determine if you are an active or passive investor to know if the passive activity loss rules apply to you. These rules may limit your ability to use losses from passive activities to offset income from other sources.

Passive Losses

If you are a passive investor in a business activity, you may only use losses from that activity to offset income from other passive activities. "Investor," to some degree, implies passive involvement. Assume for now that if you spend less then 500 hours a year on a business activity, you are a passive investor. There is one other catch. The tax code specifically excludes portfolio income and gains from passive activity income. This means that you can't offset your passive losses against portfolio income or gain. In order to generate passive activity income, which is necessary for using passive activity losses, you must be a passive investor in a profitable business activity.

How Can Understanding the Classification of Earnings and Losses Help You ato Save Money on Taxes?

Successful investment tax planning is built on understanding how different types of investments are taxed. As noted above, the tax rate applicable to your investment earnings depends (in part) on the classification of your earnings as ordinary income, qualifying dividends, or short- or long-term capital gains, and reducing taxable income depends (in part) on the classification of your losses. You have some control over the type of income you earn, the type of losses you generate, and when investment earnings are taxed. The appropriate investment decisions can deliver tax savings and thus enhance your after-tax rate of return.

Selecting Investments to Control The Type of Income You Earn

You can buy or sell investments in order to produce ordinary income, qualifying dividends, or capital gains. Generally, qualifying dividends and long-term capital gains are more favorable, but ordinary income may be desirable in certain situations.

For instance, ordinary income is advantageous when you have excess ordinary deductions or losses. You may be able to time your investment income with this in mind. If you have excess year-end ordinary losses, you might be able to purchase an investment, such as shares in a money market mutual fund that will deliver an ordinary income dividend before the end of the year.

The same is true if you have a capital loss. You can sell assets with built-in capital gains or you can purchase an investment, such as a mutual fund, that will distribute capital gains to shareholders. The goal is to generate sufficient income and/or gains to match your losses (in order to shelter earnings with your otherwise unused losses and deductions). You may also prefer some ordinary income for nontax reasons.

Selecting Investments to Control the Type of Losses You Generate

You can buy or sell investments to produce ordinary or capital losses. You may be able to generate a paper loss (one with no real economic impact) that can then be used to offset income or gain. For instance, with some restrictions, you can invest in a business that will have losses in the first few years of operations but that will eventually turn a profit.

These ordinary losses, subject to certain limitations, may be used to offset income. In addition, you can sell depreciated property and then invest in similar investments — or even in the original investment (with certain restrictions). You incur a paper loss offsetting your capital gains. There are a number of restrictions on these types of transactions, especially when the transaction is motivated by tax reasons. However, there are still opportunities to structure your affairs to make optimum use of losses and deductions.

Controlling When Your Investment Earnings Are Taxed

Investment appreciation is generally not taxed until the appreciation is realized through a sale or other disposition of the investment asset. Income distributions are generally not taxed until you receive them and expenses are deductible when paid. You may be able to control when you make these deductible expenditures and when you sell depreciated property. Since taxation is built around annual accounting, your income, deductions, gains, and losses are grouped into specific periods of time. If you can control realization of your income, gains, deductions and losses, then you may be able to time your transactions to produce tax savings for any given period.

Electing to Include Net Capital Gain In Investment Income

Taxpayers are allowed to treat net capital gain as income from property held for investment (i.e., turning capital gain income into ordinary income). This may be beneficial if an investor does not have capital losses to offset capital gain, but has investment expenses (investment expenses may only be used to offset investment income). Dividends that are eligible for capital gains tax treatment also qualify for such an election. The taxpayer must specifically make this election. If an election is not made, the IRS will assume the income is capital gain income.



This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of  The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.


The Retirement Group is not affiliated with nor endorsed by,,,,, ING Retirement, AT&T, Qwest, Chevron, Hughes, Northrop Grumman, Raytheon, ExxonMobil, Glaxosmithkline, Merck, Pfizer, Verizon, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that focuses on transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.


The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at

TRG Retirement Guide

Tags: Financial Planning, Lump Sum, Pension, Retirement Planning