How Investments Are Taxed

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Monday, October 04, 2010 10:13 AM

Tax Killers

This is about Activity Based Tax planning - maximizing deductions, minimizing cash outlay and maximizing the amount of cash retained and the net worth.

Tax is a subject that many view in order to cut costs.  Taxes are a cost just as any other cost.  It happens this cost is somewhat intangible and is defined by legislation without a tangible item to view and control.  The money is spent and the control of the expenditure is more appropriately administered by someone trained in the tax law.

The Tax Code does not tax all investments, nor all investment income the same way or by the same percentage. There are wide discrepancies in how the Internal Revenue Service treats different investments and different investment categories. Therefore, to be a savvy or foxy investor you must know the rules of the game.

In general, Uncle Sam benefits or reduces the taxes for investors seeking long-term capital appreciation, and treats more harshly investors seeking short-term gain or income. 

Investment income might be classified in three basic forms: cash payments, distributions and unrealized appreciation (or loss).

Annual cash payments, such as dividends and interest, and short-term capital gains are taxed at your ordinary marginal tax rate, which can be as high as 35 percent; with higher rates forecasted depending upon tax legislation. (Short-term is defined as a year or less.) 

However -  long-term capital gains are taxed anywhere from 0% to 28%; with rates that can be more after 2010.  For many taxpayers, but not all, the rate might be in the 15% bracket (however, the democrats and the president in office 9/2010 want to raise the long-term investment tax rates to 20% or more).  An advantage of unrealized appreciation is that you do not pay the tax, until you sell or trade, or pass-on (a lovely thought, isn't it).   This deferral aspect can save you a lot of money in the long run.  However, some types of investments such as mutual funds distribute capital gains to you - usually at year end.

For investing not in an Individual Retirement Account or some other tax-deferred vehicle, what does all this mean to you?  Why does the IRA become excluded.  Because:  The IRA is tax deferred (see my note on the Roth IRA) - meaning you do not pay any income tax annually.  HOWEVER: the IRA draw is ENTIRELY ordinary income - meaning you lose the preferred capital gain treatment.

Mutual funds: The tax implications of funds are far more complicated than with either stocks or bonds, bought individually. You might buy a fund for either share appreciation, income, or both, depending on the fund. 

Funds provide three types of income: regular dividends, realized capital gains, and unrealized capital gains (in effect, the rise in the fund's share price.) The first two are paid and taxed annually. Only the third is deferred until you cash out.

Tax Efficiency: Mutual funds with higher percentages of unrealized gains have become popularly known as "Tax Advantaged Investments."   Your Certified Public Accountant will help with understanding your tax rates, and your personal needs for income.

You must remember that the investor does not control when mutual funds distribute capital gains. You as an individual investor can decide when to realize the appreciated value (unrealized capital gain/loss) by controlling when to sell and which lots to sell.  Your Certified Public Accountant as your tax preparer can help with the tax planning.

Stocks: You buy a stock with the hope of receiving dividends or selling the stock later at a higher price. 

If the majority of stock income comes from capital gains, capital gain is only taxed when you sell. (There can be exceptions to this 'rule of thumb', so you will need to counsel wiht your Certified Public Accountant whenever you receive distributions, stock, or sell the stock.) For most investors, the ordinary marginal tax rate is higher than the largest long-term capital gain rate for the individual. So stocks tend to be very efficient on a tax basis, particularly if they are held for relatively long periods of time - at least 12 months so the investor is in compliance with the Tax Law - again consult with your Certified Public Accountant.

Bonds: Investors often will buy bonds for the bond's semiannual coupon payment. Since, bonds mature at par, there is very little opportunity to make significant capital gains, unless the bonds are purchased in the secondary market at a discount, or the bonds are traded before the maturity date. An early disposition might also produce a loss for income tax computations.  Since bonds have interest, the interest accruing between interest payment dates will need to be used in the computation of gains or losses, and in the amount of interest to include in interest income.  The details are intentionally omitted from this short discussion - you will need to ask a Certified Public Accountant to assist.

The economy, money supply, federal reserve policies, and many other factors have the potential to change the price you pay or receive for bonds - you need to become aware how the changes will impact the income tax computations. To keep this short, if the value of a bond increases, you have taxable income, on the other hand if the value of a bond decreases, you will have a tax write-off of the loss (however even this has the "if, and, but" factor; the loss might not be deductible if you do not have capital gain profits).  In general, the vast majority of bond income comes from interest payments, which is all taxed at ordinary rates. Bonds are not considered to be very tax-efficient by many Certified Public Accountants.  Bonds bought at any time other than the original issue will be bought at a price other than par.  You will have a gain or loss on the  bond - even if you hold it to maturity.  Furthermore, you will need to make decisions whether to write off for income tax purposes any premium paid annually, or wait until you sell the bond.  In addition, when you buy the bond, nearly always there will be accrued interest included in your purchase price - you must study the tax impact, or hire a Certified Public Accountant to make the determination for you.

Zero-coupon bonds: Zeros are sold at deep discounts and do not pay annual interest in cash to you.  The IRS requires that you pay tax on the paper-gain as if it were interest paid each year until maturity.

Treasury bills are actually zeros. Since their maturity is so short, no more than a year, you pay tax on the interest earned at maturity.

U.S. savings bonds: Federal bonds in general are exempt from state and local taxes. Saving bonds are taxed only when you cash them in. So they offer tax deferral.  EXCEPT for Series EE, which you can elect to pay tax on each year.

Municipal bonds: "Munis" are generally exempt from federal tax (there are exceptions, and even tax-free income might make more of your Social Security taxable - hire a Certified Public Accountant.). They are also usually exempt from state and local tax if purchased within the state they are issued.  This is a very big tax benefit for most taxpayers.  You should make computations or have a CPA make computations to compare taxable and tax-exempt yields to be sure you are doing what you want.  However some people have enough savings to support themselves at the low earnings rates for the municipal bonds.  These individuals may find life is much more simple and has less headaches if they want to be satisfied with the lower yield of these types of investments.  By steering away from any bond that is subject to the Alternative Minimum Tax, you can reduce the income tax to nearly $0.

If a municipal bond value increases, there are opportunities to earn capital gains on the municipal bond (each bond is different, and your bond or bonds might have losses). Capital gains on the municipal (aka "tax-free") bond carry no tax exemption and are taxed like any other type of bond.  Special tax computations need to be made to compute tax-free portions, capital gain, or capital loss, when there are premiums or discounts on the purchase of a bond, and for the amount of interest bought with the purchase of the bond.  Your CPA is the best choice for assistance.

Money market funds: Money Market funds by nature normally do not have capital gain distributions, or unrealized gains.  The tax affect is you pay tax at ordinary rates on the interest earned.

Annuities: Tax deferral is one reason investors purchase annuities.  These are long-term investment contracts manufactured only by life insurance companies.

Annuities often are tax-deferred, with no limit on contributions. You buy one, with a lump sum - or a series of payments. Annuities come in the form of immediate drawing, or in the form for which any draws are deferred more than a year after the initial purchase.

Considering income taxes, all gains are taxed at ordinary rates, so giving up the lower capital gains rate can be costly. Calculating the amount of taxable income each year can be a little "tricky" and is not a part of this educational material.  Annuities are complicated, and should be purchased only after careful thought.  Moreover, estate, death, or gift taxes might apply, so you need to get counseling for income tax and other reasons.

In addition - some states do not allow judgments, settlements, personal injury or other types of problems to invade the money in an annuity.  You need to ask legal counsel in your state of residence.

One thing you might want to consider is setting up some of your investment money in off-shore trusts. The off-shore trust provides no U.S.A. tax benefit.  As a U.S.A. taxpayer, one is taxed on world-wide income.  The off-shore trust in a tax haven is a neutral tax affect.  However, since under current law, the U.S.A. does not have jurisdiction over foreign trustees, then the money is out of reach from the U.S.A. court system.  Protocol changes all the time, so there may be, and one should expect, the potential for arrangements made between or among countries to compel repatriation, levy, seizing, or other methods of confiscation (and potentially enforcement in the jurisdiction of the custodian, the jurisdiction of the settlor's domicile, and potentially other jurisdictions) - check with a professional knowledgeable about these matters.

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