Investment Tax Basics For All Investors

"[N]othing can be said to be certain, except death and taxes.” —Benjamin Franklin

The founding father’s famous axiom is as true today as the day he wrote it, which means investors need to understand what the government takes.

The federal government taxes not only investment income – dividends, interest, rent on real estate, etc. – but also realized capital gains. The taxman is smart, too; investors cannot escape by investing indirectly through mutual funds, exchange-traded funds, REITs or limited partnerships. For tax purposes, these entities are transparent. The tax character of their distributions flows through to investors in proportion to their economic interest, and investors are still liable for tax on capital gains when they sell.

Companies pay dividends out of after-tax profits, which means the taxman has already taken a cut. That’s why shareholders get a break – a preferential tax rate of 15% on “qualified dividends” if the company is domiciled in the U.S. or in a country that has a double-taxation treaty with the U.S. acceptable to the IRS. Non-qualified dividends – paid by other foreign companies or entities that receive non-qualified income (a dividend paid from interest on bonds held by a mutual fund, for example) – are taxed at regular income tax rates, which are typically higher. In 2013, that's a sliding scale up to 39.6%, plus an additional 3.8% surtax for high-income taxpayers ($200,000 for singles, $250,000 for married couples).

Shareholders benefit from the preferential tax rate only if they have held shares for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date. In addition, any days on which the recipient’s risk of loss is diminished (through a put option, a sale of the same stock short against the box, or the sale of most in-the-money call options, for example) do not count toward the minimum holding period.

• Case No.1: An investor who pays federal income tax at a marginal 28% rate and receives a qualified $500 dividend on a stock owned in a taxable account for several years owes $75 in tax. If the dividend was non-qualified, or the investor did not meet the minimum holding period, the tax would be $140. A top-rate taxpayer (income tax at 39.6% plus the 3.8% healthcare surtax) would owe $217 tax on a non-qualified dividend. Investors can reduce the tax bite if they hold assets, like foreign stocks and taxable bond mutual funds, in a tax-deferred account like an IRA or 401(k) and keep domestic stocks in their regular brokerage account.
  

The federal government treats most interest as ordinary income subject to tax at whatever marginal rate the investor pays. Even zero-coupon bonds don’t escape. Although investors do not receive any cash until maturity, they must pay tax on the annual interest accrual on these securities, calculated at the yield to maturity at the date of issuance.

The exception? Interest on bonds issued by U.S. states and municipalities, most of which is exempt from federal income tax. Some municipal bonds exempt from regular federal income tax are still subject to the alternative minimum tax, however. Investors should check the federal tax status of any municipal bond before they buy.

Investors may get a break from state income taxes on interest, too. U.S. Treasury securities are exempt from state income taxes, while most states do not tax interest on municipal bonds issued by in-state entities. 

• Case No.2: An investor who pays federal income tax at a marginal 33% rate and receives $1,000 semi-annual interest on $40,000 principal amount of a 5% corporate bond owes $330 in tax, leaving $670. If the same investor receives $800 interest on $40,000 principal amount of a 4% tax-exempt municipal bond, no federal tax is due, leaving the $800 intact. Even a top-rate taxpayer would owe neither federal income tax nor the healthcare surtax. Investors subject to higher tax brackets often prefer to hold municipal bonds rather than other bonds in their taxable accounts. Even though municipalities pay lower nominal interest rates than corporations of equivalent credit quality, the after-tax return to these investors is usually higher on tax-exempt bonds.

Uncle Sam’s levy on realized capital gains depends on how long an investor held the security. The tax rate on long-term (more than one year) gains is 15%, except for high-income taxpayers (in 2013, $400,000 for singles, $450,000 for married couples) who must pay 20%. High-rate taxpayers will typically pay the healthcare surtax as well, for an all-in rate of 23.8%.

Just like the holding period for qualified dividends, days do not count if the investor has diminished the risk using options or short sales (see above).

Short-term (less than one year of valid holding period) capital gains are taxed at regular income tax rates.

• Case No.3: An investor in the 25% tax bracket sells 100 shares of XYZ stock purchased at $50 per share for $80 per share. If he or she owned the stock for more than one year, the tax owed would be $450 (15% of (80 - 50) x 100), compared to $750 tax if the holding period is less than one year. In identical circumstances, a top-rate taxpayer would owe $1,302 on a short-term capital gain vs. $450 on a long-term gain.

Investors may offset capital gains against capital losses realized either in the same tax year or carried forward from previous years. Individuals may deduct up to $3,000 of net capital losses against other taxable income each year, too, while any losses in excess of the allowance are available until either offset against gains in future years or amortized against the annual allowance.

Investors can minimize their capital gains tax liability by harvesting tax losses. If one or more stocks in a portfolio drop below an investor’s cost basis, the investor can sell and realize a capital loss for tax purposes, which will be available to offset capital gains either in the same or a future year.

There’s a catch, however. The IRS treats the sale and repurchase of a “substantially identical” security within 30 days as a “wash sale”, for which the capital loss is disallowed in the current tax year. The loss increases the tax basis of the new position instead, deferring the tax consequence until the stock is sold in a transaction that isn’t a wash sale. A substantially identical security includes the same stock, in-the-money call options or short put options on the same stock, but not stock in another company in the same industry.

• Case No.4: An investor in the 35% tax bracket sells 100 shares of XYZ stock purchased at $60 per share for $40 per share, realizing a $2,000 loss, and 100 shares of ABC stock purchased at $30 per share for $100 per share, realizing a $7,000 gain. Tax is owed on the $5,000 net gain. The rate depends on the holding period for ABC – $750 for a long-term gain, or $1,750 for a short-term gain. If the investor buys back 100 shares of XYZ within 30 days of the original sale, the capital loss on the wash sale is disallowed and the investor owes tax on the full $7,000 gain – $1,050 for a long-term gain, or $2,450 for a short-term gain.

Taxes have a significant impact on the net return to investors. Detailed tax rules are available on the IRS website for dividends and for capital gains and wash sales. While careful asset placement and tax-loss harvesting can reduce the tax burden, everyone’s tax circumstances are unique. Investors should consult their own financial and tax advisors to determine the optimum strategy consistent with their investment objectives.