Investment Tax Basics for Investors

Investors should be aware that the federal government taxes not just investment income (dividends, interest, and real estate rent), but also realized capital gains.

Key Takeaways

• The holding term is important for computing capital gains taxes. Long-term investments are taxed at a reduced rate.
• Long-term (more than one year) gains are taxed at 0%, 15%, or 20%, depending on taxable income and filing status.
• For federal tax purposes, interest income from investments is normally classified as regular income.

Tax on Dividends

Dividends are paid from after-tax earnings, which implies the taxman has already taken a chunk. That’s why shareholders receive a break: a preferential maximum tax rate of 20% on “qualifying dividends” if the firm is based in the United States or in a nation with an appropriate double-taxation treaty with the United States.

Non-qualified dividends given by other foreign firms or organizations that receive non-qualified income (such as interest on bonds held by a mutual fund) are taxed at standard income tax rates, which are usually higher.

According to the Internal Revenue Service, shareholders benefit from the preferred tax rate only if they have held shares for at least 61 days during the 121-day period commencing 60 days before the ex-dividend date.

Furthermore, any days on which the shareholder’s risk of loss is reduced (for example, by selling a put option, selling the same stock short against the box, or selling most in-the-money call options) do not count against the required holding time.

For example, an investor who pays 35% marginal federal income tax and gets an eligible $500 dividend on a stock held in a taxable account for many years owes up to $100 in tax. The tax is $175 if the dividend is not eligible or the investor does not satisfy the required holding period.

Investors may lower their tax liability by putting assets like international equities and taxable bond mutual funds in a tax-deferred account like an IRA or 401(k) while keeping domestic stocks in their normal brokerage account.

What Are Qualified Dividends?

Tax on Interest

The federal government considers most interest to be ordinary income, subject to taxation at the investor’s marginal rate. Even zero-coupon bonds are not immune: Although zero-coupon bonds do not pay cash until maturity, investors must pay tax on the yearly interest accrual on these instruments, which is computed at the yield to maturity at the time of issue.

The exemption is interest on bonds issued by states and municipalities in the United States, the majority of which are free from federal income tax. Investors may also be exempt from state income taxes on interest. For example, US Treasury securities are free from state income taxes, although most states do not charge interest on municipal bonds issued by in-state corporations.

Municipal bonds are often preferred by investors in higher tax rates over other bonds in their taxable accounts. Even while municipalities pay lower nominal interest rates than firms of comparable credit rating, the after-tax return on tax-exempt bonds is frequently greater.

Assume an investor pays federal income tax at a marginal rate of 32% and gets $1,000 semi-annual interest on a $40,000 principle amount of a 5% corporate bond, owing $320 in tax. If the investor earns $800 in interest on a $40,000 principle amount tax-exempt municipal bond, no federal tax is required, thus the $800 remains untaxed.

Tax on Capital Gains

Investors who invest indirectly via mutual funds, exchange-traded funds, real estate investment trusts, or limited partnerships cannot avoid paying taxes. The tax nature of their payouts is passed on to investors, who are nonetheless subject to capital gains tax when they sell.

Uncle Sam’s tax on realized capital gains is calculated based on how long an investor owned the investment. Long-term (more than one year) gains are taxed at 0%, 15%, or 20%, depending on taxable income and filing status. Days, like the holding time for eligible dividends, do not count if the investor has reduced risk via the use of options or short sells. Short-term capital gains (less than one year of valid holding time) are taxed at ordinary income tax rates, which are generally higher.

For example, a 24% tax payer sells 100 shares of XYZ stock acquired at $50 per share for $80 per share. If they held the stock for more than a year and are in the 15% capital gains bracket, the tax would be $450 (15% of ($80- $50) x 100), compared to $720 if the holding period is less than a year.

Tax Losses and Wash Sales

Tax losses may help investors reduce their capital gains tax obligation. That is, if one or more stocks in an investor’s portfolio fall below their cost basis, the investor may sell and incur a capital loss for tax purposes.

Capital gains may be offset by capital losses generated in the same tax year or carried forward from prior years. Individuals may also deduct up to $3,000 in net capital losses from other taxable income each year. Any losses that exceed the tolerance may be used to offset future profits.

The following federal income tax rates will be in effect in 2020 and 2021, based on yearly income: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

There is a snag. The IRS considers the sale and repurchase of a “substantially similar” investment within 30 days to be a “wash sale,” for which the capital loss in the current tax year is forgiven. Instead, the loss raises the tax basis of the new position, delaying the tax implications until the stock is sold in a non-wash sale transaction. A virtually similar security consists of the same stock, in-the-money call options on the same stock, or short put options on the same stock—but not shares in another business in the same industry.

For example, a 35% tax payer sells 100 shares of XYZ stock acquired at $60 per share for $40 per share, resulting in a $2,000 loss; the same investor also sells 100 shares of ABC stock purchased at $30 per share for $100 per share, resulting in a $7,000 gain. The $5,000 net gain is subject to taxation. The rate for ABC is determined by the holding period—$750 for a long-term gain (if taxed at 15%) or $1,750 for a short-term gain.

If the investor buys back 100 shares of XYZ within 30 days of the initial transaction, the wash sale capital loss is rejected, and the investor must pay tax on the whole $7,000 gain.

The Bottom Line

Taxes are always changing and may have a substantial influence on an investor’s net return. The IRS website has detailed tax laws for dividends, as well as capital gains and wash sales. Given the complexities of these requirements, investors should seek the advice of their own financial and tax professionals to establish the best plan compatible with their investment goals and to ensure that their taxes are filed in line with regulations.

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