As the famous saying goes, only two things in life are certain: death and taxes. Most of us understand how our paycheck drives our taxes — we earn money, and the federal government taxes it.
But how do our investments drive our taxes? What actions trigger taxes? What actions mitigate taxes? And what choices might be driving up (or driving down) our taxes?
In my ongoing effort to help you, dear reader, understand all things personal finance better, this month's edition of Wealth Management 101 will answer the question: "When exactly do my investments get taxed?"
Always check with your tax advisor to be sure how tax law applies to your specific situation. This article is a general guide only. Remember, Baird does not offer tax advice.
As with the money we earn through labor, what gets taxed is income. But what exactly is considered income?
When you own bank deposits, money market funds, bonds, or bond funds, you are likely earning some amount of interest income.
You may take the interest earned as cash, or you may reinvest it.
Regardless of what you do with the interest you are paid, those payments are classified as income and taxed just like the income you earn from labor. This type of income is said to be taxed like ordinary income.
What throws most people for a loop is that unlike your earnings from labor, there is no withholding for these taxes done on your behalf. Interest income is typically reported on Form 1099 and/or Form 1099-INT. You'll use those forms when reporting your income when you file your taxes.
Certain stocks, stock mutual funds, and stock exchange-traded funds pay dividends. As with interest, you may take those dividends as cash, or you may reinvest them.
Once again, regardless of what you do with your dividend payments, those payments are taxable.
How they are taxed depends on what category they fall into. I won't bore you with the precise criteria, but a dividend payment may be either qualified or unqualified.
Qualified dividends are taxed at the more favorable long-term capital gains tax rate rates. Unqualified dividends are taxed at the less favorable ordinary income tax rates.
As with interest income, there is no withholding done on your behalf here. This type of income is reported on Form 1099, which you'll use when reporting your income at tax filing time.
This next part can trip up a lot of investors: realized gains.
Let's say you buy an investment for $100. Two years pass.
There are three things that could happen.
Thing One: You Continue to Own the Investment
If you continue to hold the investment (and it does not pay a dividend or interest), then there will be no tax impact. Until you sell the investment (or earn a dividend or interest), there is nothing to tax.
Thing Two: You Sell the Investment for More Than You Paid
If you bought the investment for $100 and then sell it for $200, you have a realized gain of $100. Only the gain of $100 is taxable. The dollars used to buy the investment were taxed previously and are not subject to taxation again.
Thing Three: You Sell the Investment for Less Than You Paid
If you bought the investment for $100 and then sell it for $50, you have a realized loss of $50.
Here's the twist: You can use that loss to offset any realized gains you might have. Let's say you sold another investment during the year with a realized gain of $100. You can deduct $50 from that gain for the loss you took. Now you'll pay taxes only on $50 worth of realized gain.
Here's the key point: To trigger any capital gains tax consequence on an investment, there must be a transaction.
As with interest income and dividend income, there is no withholding done on your behalf here. This type of income is reported on Form 1099, which you'll use when reporting your income at tax filing time.
Another thing that tends to blindside investors is distributed capital gains.
If you own mutual funds (be they stock or bond funds), you may have distributed capital gains in any given year.
A mutual fund is not taxed at the entity level. That is to say, the fund itself does not pay taxes. In order to qualify for this treatment, the mutual fund must distribute its realized gains in any given year to each shareholder.
As with our example above, if the fund bought an investment for $100, and later sold it for $200, it must distribute that $100 gain among its shareholders by year-end. Each shareholder is in turn obligated to pay taxes on that distributed capital gain — regardless of whether the distributed gain was received in cash or reinvested.
It's a good practice to review your mutual funds at year-end to see if any capital gains were distributed. If they were, and you have unrealized losses, you may wish to realize those losses to offset the distributed gains. We call this tax loss harvesting.
Short-Term vs. Long-Term
In our example above, I specified that the investment was held for two years. This was not an arbitrary choice. With capital gains, the period of time the investment is held matters.
If you own an investment for 365 days or less, any realized gain (or loss) is classified as short-term. Short-term gains are taxed like your labor, interest income, and unqualified dividends — at ordinary income tax rates.
If you own an investment for 366 days or more, any realized gain (or loss) is classified as long-term. Long-term gains are taxed at the more favorable capital gains tax rate.
What Do I Pay?
The last thing to unpack here is the applicable tax rates.
If your eyes are glazed over, you can stop here; we've covered the most important stuff.
But if you're the curious type, read on.
There are two sets of tax rates that apply to most taxpayers: ordinary income and capital gains.
The ordinary income tax rates dictate what you'll pay on the income you earn on your labor, your interest, your unqualified dividends, and your short-term capital gains. These rates are generally higher, so having labor, interest, unqualified dividends, and short-term capital gains will have a relatively bigger impact on your tax bill.
The capital gains tax rates dictate what you'll pay on long-term capital gains and qualified dividends. These rates are generally lower, so having long-term gains or qualified dividends will have a relatively smaller impact on your tax bill.
Minimizing the Impact
"I LOVE paying taxes!" said no one ever. So how do we minimize the toll that taxes take on your portfolio?
There are some very simple things you can do.
- Save in tax-advantaged accounts. These include your employer retirement plan, deferred compensation plan, IRAs, Section 529s, or certain insurance products. Your choice of account or insurance product and how much you invest should be driven by your immediate need to access cash, your goals, your risk tolerance, and your time horizon.
- Choose relatively tax-efficient investments. Those might include exchange-traded funds (which do not have distributed gains), certain individual stocks (that do not pay a dividend), or municipal bonds (where interest income is not taxable at the Federal level).
- Minimize trading in your taxable accounts. If you don't sell, you don't realize a gain, and you aren't taxed. That's not to say you should never sell an investment, but you should seek to behave more like a buy-and-hold investor rather than a day trader.
- Harvest losses when you can. Because realized losses can be used to offset realized gains, it's useful to hunt for any unrealized losses at year-end. You can strategically realize those losses to offset any gains you've already realized.
I get it. Taxes are complicated, and by now your head may be spinning. Fortunately, there are CERTIFIED FINANCIAL PLANNER™ Professionals and Financial Advisors like me who can help you build a mix of accounts and investments designed to serve your goals while taking as much of the sting out of tax time as we can.
Ready to get started?
Robert W. Baird & Co. Inc. does not offer tax or legal advice.