After the first of the year, people begin to think about how much they will owe Uncle Sam on their investment returns. Oftentimes, people really don't understand how to forecast or calculate that IOU. For starters, there is a difference between how various types of investments are taxed. Here are some pointers to help you understand how your investments are taxed:
Stocks. Stocks make money for you with dividends and capital gains. Dividends are taxed at two different rates—ordinary income rates for non-qualified dividends and a 15 percent level for qualified dividends. (Thanks to the Bush tax-cut extensions, the 15 percent rate still holds true.) Check to make sure your dividends are qualified for the better tax treatment.
[See The Tale of Two Taxes.]
Capital gains can be long term for investments held longer than 12 months, or short term for those held shorter than 12 months. Long-term gains are taxed at the 15 percent level (again thanks to the Bush tax-cut extension) and short-term gains are taxed at your ordinary income rate.
Bonds. Bonds usually pay interest, but may also have some capital gains. The interest is taxed at your ordinary rate and capital gains are taxed at the short-term or long-term gain rate depending on the holding period. Municipal bonds are not subject to income tax, but could have capital gains, which will be taxed accordingly.
Keep in mind that having a lot of municipal bond interest or a lot of long-term capital gains could also trigger the Alternative Minimum Tax (AMT), which can cost 26 or 28 percent depending on total gross income. AMT is that pesky tax the government put into place in 1969 to penalize the small number of tax payers that were getting away without paying taxes due to exploiting loopholes in the tax code. The issue with the AMT is that it has not been adjusted for inflation, which subjects millions of Americans to the additional liability.
Mutual funds. Mutual funds are taxed just like stocks and bonds except for one main item—with stocks you only have to pay tax on the gain once you sell it. With mutual funds, it doesn't matter when you sell your funds (although that can and probably will trigger a tax). A tax is owed when your fund manager makes a trade that has a gain. Sometimes, your manager could have made a winning trade right before you buy into the fund. While you may not experience the gain in your portfolio because you bought in well after the initial purchase (of the manager's winning stock), you could still incur the total tax of the trade. That is why many investors do not like mutual funds. However, they are a good, flexible, marketable security for many types of investors.
There are a few additional items that are important to note. For instance, investment companies are required to mail your 1099 statement of gains and losses by the end of January. However, periodically mutual fund companies (due to the complexity of qualified dividends) may ask the IRS for an extension or may send out an amended 1099. If that is the case, you may have to file an amended return. For that reason, it may be beneficial for you to file your taxes in late February or even in March.
Also, your gains can be offset by your losses even if they are from prior years. Losses that you are not able to claim in the current tax year can be saved indefinitely for future years. This is considered "capital loss-carry forward." Losses from your investments can first be taken against gains in your portfolio and then against ordinary income of up to $3,000 per year.
This is not a complete list of tax items to be aware of, but it certainly provides you with some of the most important. Good luck and think tax efficient.
Kelly Campbell, Certified Financial Planner and Accredited Investment Fiduciary, is founder of Campbell Wealth Management, a Registered Investment Advisor in Fairfax, Va. Campbell is also the author of Fire Your Broker, a controversial look at the broker industry written as an empathetic response to the trials and tribulations many investors have faced as the stock market cratered and their advisers abandoned their responsibilities to help them weather the storm.