Tax Basics for Investors – Aaron Steele
This article delves into tax choices such as dividend tax, interest tax, capital gains tax, and how harvesting tax losses can minimize capital gains tax.
Dividend tax
You are undoubtedly aware that firms pay dividends after paying tax on their original profits as business owners. This is why on “qualified dividends,” owners in the United States or nations with which the United States has a double-taxation treaty receive a preferential maximum tax rate of 20%.
On the other hand, foreign corporations and companies that get non-qualified income pay conventional income tax rates, which are typically higher.
According to the Internal Revenue Service (IRS), shareholders can only profit from the preferred tax rate if they have held shares for at least 61 days during the 121 days beginning 60 days before the ex-dividend date. Those days do not count against the minimum holding time when the shareholder’s risk of loss is decreased,
In the case of an investor who pays a marginal federal income tax rate of 35% and has a taxable account with a tax liability of $100, he receives a $500 dividend on stock. The tax rises to $175 if the necessary holding rate is not attained or the dividend is not qualified.
Investors that have assets in a deferred account such as taxable bonds, overseas stocks, and a conventional brokerage account where they keep domestic stock have decreased their tax burden.
Interest tax
Most interests are taxed by the federal government as ordinary income, depending on the investor’s marginal rate.
Interest bonds issued by states and municipalities in the United States are tax-free. Investors may also be exempt from state income taxes on interest. Most states do not charge interest on municipal bonds issued by in-state entities.
Municipal bonds are preferred by investors subject to higher tax brackets over other bonds in their taxable accounts. Municipalities with lower nominal interest rates typically give investors a larger after-tax return on tax-exempt bonds than firms with similar credit ratings.
Consider an investor who pays a marginal federal income tax rate of 32% and receives $1,000 in semi-annual interest on a $40,000 principal amount of a 5% corporate bond but owes $320 in taxes. If an investor receives $800 in interest on a $40,000 principal amount of a 4% tax-exempt municipal bond, then no federal tax is due on the $800.
Tax on Capital Gains
Investors cannot avoid paying taxes by investing in mutual funds, exchange-traded funds, real estate investment trusts, or limited partnerships. Because of the tax character of dividends, investors are still subject to capital gains tax when they sell.
Research shows that the tax on realized capital gains is based on how long the investor has owned the security. Long-term gains (greater than a year) are taxed at a rate of 0%, 15%, or 20%, depending on your taxable income and filing status. Days do not count if the investor has minimized risk by using options or short sales, just as they do for eligible dividends. Short-term capital gains (those held for less than a year) are taxed at ordinary income tax rates, often higher.
In the case of a 24% tax bracket, an investor selling 100 shares of XYZ stock for $80 each after obtaining them for $50 each—if they owned the stock for more than a year and are in the 15% capital gains bracket, the tax due would be $450 (15 percent of ($80 – $50) x 100), compared to $720 if they only held it for a year.
Wash Sales and Tax Losses
Investors can lower their capital gains tax liability by harvesting tax losses. For instance, if one or more stocks in an investor’s portfolio fall below their cost basis, the investor can sell and realize a tax loss.
Capital gains can be offset by capital losses incurred in the same tax year or carried over from previous years. Individuals can deduct up to $3,000 in net capital losses from their other taxable income each year. Any losses that exceed the tolerance can be used to offset gains in the future.
The federal income tax brackets for 2020 and 2021 are 10%, 12%, 22%, 24%, 32%, 35%, and 37%, dependent on the annual income.
However, there is a catch. The IRS considers a “wash sale” when a “substantially similar” security is sold and repurchased within 30 days, and the capital loss is forgiven for the current tax year. Instead, the loss improves the tax basis of the new position, deferring the tax payment until the stock is sold in a non-wash sale. The same stock, in-the-money call options, and short put options on the same stock are all deemed substantially comparable securities but not shares in another company in the same industry.
An investor in the 35% tax bracket, for example, sells 100 shares of XYZ stock purchased at $60 per share for $40 per share, a $2,000 loss, and sells 100 shares of ABC stock purchased at $30 per share for $100 per share, a $7,000 profit. Taxation is due on the $5,000 net gain. The rate is decided by how long ABC has been held—$750 for a long-term gain (if taxed at 15%) or $1,750 for a short-term gain (if taxed at 15%).
If the investor buys back 100 shares of XYZ within 30 days of the original transaction, the capital loss on the wash sale is rejected, and the investor must pay tax on the entire $7,000 gain.
Conclusion
Taxes are subject to change and can have a significant impact on an investor’s net return. Dividends, capital gains, and wash sales are all covered in detail on the IRS‘ website. Given the intricacy of these rules, investors should seek the guidance of their own financial and tax advisors to determine the best strategy for their investment goals and ensure that they are properly reporting their taxes.
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