Learn the Basics of Investment Taxation from a Wealth Advisor Near Me, and Start Investing More Efficiently

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As you probably know, virtually any monetary earnings or gains in your life are taxable, and investment earnings are no exception.  We just can’t escape taxes. There is some good news, however. First, if you are getting taxed on your investments, it generally means you have made gains. And, while not as good as gains, investment losses can be used to offset other gains or income, therefore reducing your taxes. 

More importantly, a basic knowledge of investment taxes can help you avoid big mistakes, reduce the impact of taxes, and improve the efficiency of your investments. So read on to learn the basics principles of investment taxation and apply the lessons to your investment plan.

Dividends, interest, and capital gains here in Austin Texas

When you invest an amount of money in stocks, bonds, or investment funds, you are buying investment units worth the same amount. A $10,000 invested in a company that sells for $40 per share means you buy 250 shares of that company. The $10,000 is the cost of your investment. The same reasoning applies to any other stock or bonds, or mutual funds and ETF. Any time you invest, you buy shares or units of the investment, and the investment amount is the cost of your investment.

Over time, the units you own make payments and can increase in value. Examples of payments are dividends paid by stocks and coupon payments made by bonds, both of which are taxable. When you sell a number of the investment units you own at a gain relative to the cost of that investment, that gain is taxable. If the price per share increases to $45 in the above example, the value of your investment goes up to $11,250. The investment has an “embedded” or “unrealized” gain of $1,250. If you do not sell, the gain is not taxable. But if you sell all or a fraction of the investment, your embedded gain becomes taxable. If you sell half of your investment, your taxable gain is $625.

What to Ask a Wealth Advisor near me about mutual funds and ETFs?

Most investors hold investments like stocks and bonds in a mutual fund or ETFs. In this case, you are buying shares of a fund that invests in stocks, bonds and other investments. If a fund’s price is $40 per share and your investment is $10,000, you are paying $10,000 for 250 shares of the fund. Every cash dividend or coupon payments made by the stocks or bonds to the fund are passed on to you, and are taxable. And when the fund sells an investment it owns at a gain, it passes on that gain to you.

How are dividends taxed?

Dividends are payments of income from companies in which you own stock, either directly or through a mutual fund or ETF. How much dividends are taxed depends on whether they are “qualified” or “nonqualified.” 

Qualified dividends are treated as capital gains from a tax perspective. Capital gains tax rates can be 0%, 15% or 20% depending on your level of taxable income, and are generally lower than ordinary income tax rates. So qualified dividends have special status. Most payments from U.S. corporations are qualified as long as you hold the investment for more than 60 days. In order for dividends passed through by a fund to be qualified, the fund must first meet the 60-day requirement, and the owner of the fund must own the fund shares for more than 60 days.

Nonqualified dividends are treated as ordinary income and are subject to your marginal tax rate. International stocks and stock funds have a higher percentage of non qualifying dividends than funds that invest solely in US stocks. Dividend income is reported to you in the form 1099-DIV that you receive from your broker.

How is interest income taxed in Austin TX? Ask a Wealth Advisor near me

Regular coupon payments by bonds are considered interest income and taxed at your marginal income tax rate. If you own bonds or money market funds through a mutual fund or ETF, the interest payments will go to the fund and will then be passed on to you as “interest dividends,” which are treated as interest for tax purposes. Interest on individual securities is reported to you on Form 1099-INT while the interest passed to you by funds is reported on Form 1099-DIV.

Income from bonds issued by state, city, and local governments (municipal bonds, or munis) is generally free from federal taxes, although some muni bonds are subject to the ATM (alternative minimum tax) system. On the other hand, income from government bonds is generally free from state and local taxes.

How are realized gains taxed?

You realize a capital gain when you sell an investment at a price greater than what it cost you, like in our stock example above. The cost was $40 per share and the sale price $45 per share. If you don’t sell, you have an embedded or unrealized gain of $5, but not a realized gain. Only realized capital gains are taxed. How much they are taxed depends on your taxable income and how long you have held the investment.

If you have owned your investments for more than one year at the time of sale, your gains are considered long-term. Long-term gains are taxed at a 0%, 15%, or 20% tax rate, depending on your level of taxable income.

If you have owned the investments for one year or less your gains are considered short-term. Short-term gains are taxed at your ordinary income tax rate. 

If you invest in a mutual fund or ETF, you may have realized capital gains even if you don’t sell any fund shares. The reason is that the fund may be selling some of the stocks or bonds it holds, and the tax liability is passed on to you. Whether the capital gain is considered short-term or long-term depends on how long the fund has held the investment.

What this means for fund investors, ask a Wealth Management Advisor

When you buy a mutual fund or an ETF, you are delegating the management of your investments to a professional manager. The fund receives dividends, interest, and capital gains on the investments it makes. These cash payments and realized gains are passed on to you in the form of a fund distribution. Capital gains are typically distributed once a year in December, while dividends are distributed quarterly or monthly depending on the funds. These arrangements have some implications that investors should consider:

• When you buy a fund (or a stock) that is about to make a distribution, the price will include the value of the dividends. When the distribution is paid, some of that cash is paid back to you, and it becomes a tax liability. If you are investing a large sum, avoid investing right before a dividend payment. However, if you are making small regular contributions, don’t change your plan because of dividend payments.
• If the fund realizes capital gains, you may be subject to capital gains taxes even if you haven’t sold any fund shares. This can happen even in a down market when the fund has lost value. 
• When you buy a mutual fund or an ETF, you are also buying any unrealized gains it has, and you will be subject to eventual taxation when the fund sells the shares. If you can, avoid buying a fund right before the capital gains distribution.

Discuss these principles to select investments with a Fee Only Financial Advisor

We have touted before the advantages of a more passive approach to investing. One of these advantages is tax efficiency. Active funds that select stocks or industries or time the market tend to trade more often. Many active funds have turnovers of greater than 100% per year, and some over 300%. This means that the average stock is held in the fund’s portfolio for less than a year. As a result, any capital gains they realize are likely to be taxed as ordinary income. For the same reason, their dividends are more likely to be nonqualified. 

We can take this a step further. Narrower and more selective funds, targeting a particular industry, sector, or commodity, typically trade more. With narrow funds, you will also need to rebalance your portfolio more often, generating potential taxable gains.

If you are concerned about taxes, stay away from actively traded funds and check the turnover of the fund, which is a measure of the intensity of trading of a fund. You can find turnover information for a fund in the fund prospectus.

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We only scratched the surface of the implications of our tax system for investors. However, understanding these simple concepts can help you understand your potential tax bill and form the basis of tax-efficient investment strategies. Stay tuned for more on this subject!

Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC.  DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives.  As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice. Massi is also a faculty of Finance and Economics at the McCoy College of Business at Texas State University.