12/27/2013 4:30 PM ET|
How Uncle Sam pinches your portfolio
Making educated decisions about your savings and investments could save you money by avoiding common taxes.
"…nothing can be said to be certain, except death and taxes." - Benjamin Franklin
The founding father's famous axiom is as true today as the day he wrote it, which means investors need to understand what the government takes.
The federal government taxes not only investment income - dividends, interest, rent on real estate, etc. - but also realized capital gains. The taxman is smart, too; investors cannot escape by investing indirectly through mutual funds, exchange-traded funds, REITs or limited partnerships. For tax purposes, these entities are transparent. The tax character of their distributions flows through to investors in proportion to their economic interest, and investors are still liable for tax on capital gains when they sell.
Tax on dividends
Companies pay dividends out of after-tax profits, which means the taxman has already taken a cut. That's why shareholders get a break - a preferential tax rate of 15 percent on "qualified dividends" if the company is domiciled in the U.S. or in a country that has a double-taxation treaty with the U.S. acceptable to the IRS. Non-qualified dividends - paid by other foreign companies or entities that receive non-qualified income (a dividend paid from interest on bonds held by a mutual fund, for example) - are taxed at regular income tax rates, which are typically higher. In 2013, that's a sliding scale up to 39.6 percent, plus an additional 3.8 percent surtax for high-income taxpayers ($200,000 for singles, $250,000 for married couples).
Shareholders benefit from the preferential tax rate only if they have held shares for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date. In addition, any days on which the recipient's risk of loss is diminished (through a put option, a sale of the same stock short against the box, or the sale of most in-the-money call options, for example) do not count toward the minimum holding period.
Case no. 1: An investor who pays federal income tax at a marginal 28 percent rate and receives a qualified $500 dividend on a stock owned in a taxable account for several years owes $75 in tax. If the dividend was non-qualified, or the investor did not meet the minimum holding period, the tax would be $140. A top-rate taxpayer (income tax at 39.6 percent plus the 3.8 percent healthcare surtax) would owe $217 tax on a non-qualified dividend.
Investors can reduce the tax bite if they hold assets, like foreign stocks and taxable bond mutual funds, in a tax-deferred account like an IRA or 401k and keep domestic stocks in their regular brokerage account.
Tax on interest
The federal government treats most interest as ordinary income subject to tax at whatever marginal rate the investor pays. Even zero-coupon bonds don't escape. Although investors do not receive any cash until maturity, they must pay tax on the annual interest accrual on these securities, calculated at the yield to maturity at the date of issuance.
The exception? Interest on bonds issued by U.S. states and municipalities, most of which is exempt from federal income tax. Some municipal bonds exempt from regular federal income tax are still subject to the alternative minimum tax, however. Investors should check the federal tax status of any municipal bond before they buy.
Investors may get a break from state income taxes on interest, too. U.S. Treasury securities are exempt from state income taxes, while most states do not tax interest on municipal bonds issued by in-state entities.
Case no. 2: An investor who pays federal income tax at a marginal 33 percent rate and receives $1,000 semi-annual interest on $40,000 principal amount of a 5 percent corporate bond owes $330 in tax, leaving $670. If the same investor receives $800 interest on $40,000 principal amount of a 4 percent tax-exempt municipal bond, no federal tax is due, leaving the $800 intact. Even a top-rate taxpayer would owe neither federal income tax nor the healthcare surtax. Investors subject to higher tax brackets often prefer to hold municipal bonds rather than other bonds in their taxable accounts. Even though municipalities pay lower nominal interest rates than corporations of equivalent credit quality, the after-tax return to these investors is usually higher on tax-exempt bonds.
Tax on capital gains
Uncle Sam's levy on realized capital gains depends on how long an investor held the security. The tax rate on long-term (more than one year) gains is 15 percent, except for high-income taxpayers (in 2013, $400,000 for singles, $450,000 for married couples) who must pay 20 percent. High-rate taxpayers will typically pay the healthcare surtax as well, for an all-in rate of 23.8 percent.
Just like the holding period for qualified dividends, days do not count if the investor has diminished the risk using options or short sales (see above).
Short-term (less than one year of valid holding period) capital gains are taxed at regular income tax rates.
Case no. 3: An investor in the 25 percent tax bracket sells 100 shares of XYZ stock purchased at $50 per share for $80 per share. If he or she owned the stock for more than one year, the tax owed would be $450 (15 percent of (80 - 50) x 100), compared to $750 tax if the holding period is less than one year. In identical circumstances, a top-rate taxpayer would owe $1,302 on a short-term capital gain vs. $450 on a long-term gain.
Tax losses and wash sales
Investors may offset capital gains against capital losses realized either in the same tax year or carried forward from previous years. Individuals may deduct up to $3,000 of net capital losses against other taxable income each year, too, while any losses in excess of the allowance are available until either offset against gains in future years or amortized against the annual allowance.
Investors can minimize their capital gains tax liability by harvesting tax losses. If one or more stocks in a portfolio drops below an investor's cost basis, the investor can sell and realize a capital loss for tax purposes, which will be available to offset capital gains either in the same or a future year.
There's a catch, however. The IRS treats the sale and repurchase of a "substantially identical" security within 30 days as a "wash sale", for which the capital loss is disallowed in the current tax year. The loss increases the tax basis of the new position instead, deferring the tax consequence until the stock is sold in a transaction that isn't a wash sale. A substantially identical security includes the same stock, in-the-money call options or short put options on the same stock, but not stock in another company in the same industry.
Case no. 4: An investor in the 35 percent tax bracket sells 100 shares of XYZ stock purchased at $60 per share for $40 per share, realizing a $2,000 loss, and 100 shares of ABC stock purchased at $30 per share for $100 per share, realizing a $7,000 gain. Tax is owed on the $5,000 net gain. The rate depends on the holding period for ABC - $750 for a long-term gain, or $1,750 for a short-term gain. If the investor buys back 100 shares of XYZ within 30 days of the original sale, the capital loss on the wash sale is disallowed and the investor owes tax on the full $7,000 gain - $1,050 for a long-term gain, or $2,450 for a short-term gain.
The bottom line: Taxes matter
Taxes have a significant impact on the net return to investors. Detailed tax rules are available on the IRS website for dividends and for capital gains and wash sales. While careful asset placement and tax-loss harvesting can reduce the tax burden, everyone's tax circumstances are unique. Investors should consult their own financial and tax advisors to determine the optimum strategy consistent with their investment objectives.
More from Investopedia:
VIDEO ON MSN MONEY
Forty seven Percent (475) of the population of the U.S.S.A. Pays NO income tax. Of that 47%, the vast majority get money back from YOUR taxes under the auspices of [un]Earned Income Credits [EIC]. Until the population learns the facts and begins to actively protest (as in the Taxed Enough Already movement) it will just get worse.
The total taxation has gone to ridiculous levels.
25 percent Fed income tax
8 percent state income tax
7 percent employee Social security + 7 percent Social security employer has to pay
2 percent Medicare
7 percent unemployment
49 percent of the gross.
5 percent Property Tax (calculated as 2 percent of remaining 58 percent + value of the prop)
2 percent road tax + Ad valorem ( calculated as 1 percent of remaining 58 percent approx)
56 percent. : total tax calculated as percentage of the gross.
12 percent ( Medical calculated as 8 percent of the after tax 56 percent)
66 percent of the gross gone in Taxes and Medical premium.
20 percent sales tax if you want to spend the money( 8percent of the remaining 34 percent amounts to this off the gross 100 percent)
86 percent gone in straight medical and taxes of the Gross income.
14 percent left for everything else. And on top of this funding has been reduced for schools that are now asking for additional funds from parents. Roads are being sold out to rich as paid fast lanes. Road construction is being privatized to toll charging companies.
On top of that any interest or investment income is that is being generated by bearing high risk and fighting against investment vultures is also taxed in complex ways to maximize the tax.
A lot of tax breaks are advertised and you can claim those, but at the end every break is very smartly taken away in the name of AMT- the hard to understand and accurately plan for- Alternative minimum tax.
The sad part is that after this much taxation, government still feels to take loan to the tune of 18 trillion dollars from our future. This is like a 75,000 dollars debt on the name of each living man woman and child. Who authorizes this.
The spending is not under control and even the rate of deficit is not reducing forget about repaying the loans. Every day more creative ways of taxation are being devised. for example the removal of ad-valorem by the straight sales tax on cars, which adds a lot of more burden to tax payers and only the wise can understand how cunning a scheme that is to again take loan from the future. Forget the roads getting fixed in the future.
The whole piss and **** is being taxed at this point for the 50 percent, while the rest 50.. forget it...
The mega rich have their extensive loopholes to save their money. No wonder people want to immigrate out of US now and legal tax paying and well educated donot want to move here. Bush put us on a wrong track and Obama has not even slowed the pace forget turning around.
And Obamaville's politically and socio-economically downtrodden just keep voting for a more intrusive government that continues to put them farther behind - mmm, mmm, mmm!
This is a great example of the insatiable greed of the federal government. The dividends are paid out of after-tax corporate income which means there should be no tax on them - not a "preferential rate" of 15%. What's worse is the death tax which, other than unrealized capital gains, also taxes after-tax income. The heirs should only have to pay capital gains on the inherited assets when they sell them.
And what does the federal government do with all this money? They use about 20% of it to make poor people more comfortable - not to end poverty. BTW they use about 15% of it for defense which is their primary responsibility.
Why does someone spend $40,000,000.00 to get elected to the Senate or the House where they get paid $174,000.00?
Why does a politician get elected when he is worth a few million and leave office worth a bunch of millions?
Why can the IRS ruin your life if you don't pay?
Why do we feel like we are indentured servants?
Why do we have to get rid of great health insurance for Obamacare?
Why are we sending money to places that want us destroyed?
Liars figure and figures lie
for those of you who want to claim one idiot politician has done more than any other to bring the country to its current economic disaster,
that's as true as being able to push water uphill or nail it to a tree.
if people want the economy to change, society needs to stop the hypochondriacs from being able to claim to having every new disease that comes out.
stop the clowns from being able to claim they have a disease when their conditions are self inflicted and then begin to live at the expense of the rest of society.
a drug addiction shouldn't qualify any one to get their living expenses paid for at the rest of society's expense,
the same with the fact that the clowns claiming they can't deal with the fact that their lives didn't turn out the way they wanted, so they claim to be suffering from their depression and anxiety crap.
everyone and anyone trying to work and earn a living at what wages are offered are reasons alone to claim to be suffering from that crap.
stop allowing the baby factories to get more for every child they have when every one already cries and complains about how expensive it is to have the children they already have but are having even more.
i know i'm tired of having everyone cry and complain that i'm too expensive for them,
but they already cost me far more than i could ever cost them..
then tell the idiots that spend all their money on the only three things in their pathetic lives that they do,then cry and complain that every thing that has real value is to expensive.
the only three things people are willing to open their wallets for are
any thing past those three things gets nothing but complaints about being too expensive no matter what or how little they get that product and/or service for.
then people have the simple minded idea to use every online shopping service and the self checkouts when they actually do go to the physical stores to buy some thing,
then wonder in amazement why there's so much unemployment,
which also leads to less taxes being paid to the government, which eventually will lead to more local municipalities closing down.
but according to the majority of society,
the reason why the country is in such economic disaster is because people trying to serve a purpose are expecting too much from you,
not the idiots who only have a few years of drunken dorm and spring break parties for their excuse to claim to be worth $1,000,000 fresh out of college when the trades people could never even think of getting $50,000 after working a trade for decades.
then to put the icing on the cake,
you moron idiots will spend a few thousand dollars for just a couple of hours at a sporting event,
spend thousands on your gadgets that were produced mostly by computers, the products should realistically cost 10 to 20 percent of the prices you morons actually paid..
too many people are allowed to claim to be so intelligent, but have no proof.
Why do people only look at the income tax? Most federal revenue comes from other taxes; Social security ( an incredibly regressive tax, not a retirement contribution as the money goes into the general revenue and is not deposited into a trust account),gasoline and other fuel taxes, telephone taxes, the self-employment tax ( a monster of a tax designed to reduce compteetion to big business), Medicaid, unemployment taxes, license, tariffs, and other fees, etc.
Worse yet, state and local taxes are incredibly regressive, especially the sales tax. In SC, for example, the sales tax on a vehicle is limited to $ 300.00.
Overall, the wealthier you are, the less money the govt takes from you as a percentage of your income.
Copyright © 2014 Microsoft. All rights reserved.
Fundamental company data and historical chart data provided by Morningstar Inc. Real-time index quotes and delayed quotes supplied by Morningstar Inc. Quotes delayed by up to 15 minutes, except where indicated otherwise. Fund summary, fund performance and dividend data provided by Morningstar Inc. Analyst recommendations provided by Zacks Investment Research. StockScouter data provided by Verus Analytics. IPO data provided by Hoover's Inc. Index membership data provided by Morningstar Inc.