A Tax Guide for Investors
Confused about K-1s or capital gains? Here’s what you need to know.
For most people, tax time is about as much fun as taking a bath with an electric eel, and taxes on your investments can be particularly confusing and irksome. Nevertheless, if you make wise use of capital losses and gains, you may find that you owe less in taxes than you thought.
Here’s what you need to know to be tax-wise about the investments you own, or those you might be considering adding to your portfolio.
Timing is everything
If you realize a gain on an investment, you will have to pay taxes on that gain, unless it is in a tax-favored retirement account. Just how much you pay will depend on your income, your purchase price, your sale price and how long you held the investment.
Timing is crucial. Suppose you invest in SnapTat, a phone app that lets users share and compare their cool tattoos. You buy 1,000 shares at $10 apiece, for a total cost of $10,000. SnapTat stock goes up and you sell the shares for $12,000, six months after your purchase. Because you bought and sold your shares less than 12 months apart, you now have a short-term capital gain, which will be taxed at your maximum income tax rate. If you’re in the top 40.8% tax bracket, which includes a 3.8% Medicare surtax, you’ll owe Uncle Sam $816 on your gain—40.8% times $2,000.
Let’s say you wait more than a full year between your purchase and sale. Now you qualify for a more favorable long-term capital gains rate, which is determined by your taxable income. High earners whose modified adjusted gross income puts them in the top 23.8% capital gains bracket (which includes a 3.8% surtax) would owe $476 on their SnapTat gain. If your income is low enough, you won’t owe any capital gains tax.
At tax time, you match up all of your long-term gains against your long-term losses, and your short-term gains against your short-term losses. Then you match any remaining gains against remaining losses to figure your capital gains tax. Let’s say you have $10,000 in long-term gains and $6,000 in long-term losses, and you have $1,000 in short-term gains and $7,000 in short-term losses. You’ll be left with $4,000 in long-term gains to match against $6,000 in short-term losses, leaving you with $2,000 in short-term losses in the end. If you wind up with losses, you can deduct up to $3,000 worth from your income. Losses greater than $3,000 can be carried over into the next tax year and future years, until they are used up.
Qualified stock dividends are also taxed at capital gains rates. What makes a dividend qualified? Again, timing. You must hold your stock for more than 60 days sometime within the window that extends from 60 days prior to 60 days after the ex-dividend date—typically, one business day before the dividend record date. Non-qualified dividends are taxed at your ordinary income rate. If you’re investing via a mutual fund, your fund company will spell out how much of its dividend payout is qualified.
The basis of cost basis
To figure gains, you need to calculate your cost basis: the purchase price adjusted for tax purposes. It’s important to adjust your cost basis for reinvested dividends. You pay tax on dividends that you reinvest as though you’ve pocketed the cash. But you won’t be taxed twice—once when the dividend is paid and again when you sell—because your cost basis is adjusted upward by the amount of the dividend.
Say you invest $10,000 in Amalgamated Hat Rack and receive $300 in dividend payments while you hold the stock. Then you sell your shares for $12,000. To calculate your cost basis, add the $300 in dividends to your $10,000 initial investment. Your new basis is $10,300, and your gain is $1,700. Investment expenses, such as commissions, will also increase your cost basis and reduce your taxes.
Keep good records. Brokerage firms must keep records of all purchases and sales of securities for at least six years, and many keep them longer. Vanguard, for example, keeps trade confirmations back to 2008.
LIFO or FIFO?
If you sell a portion of your stocks or funds, you have four choices: You can sell shares in the order you bought them—first in, first out, or FIFO. This will increase the odds that you’ll pay the lower long-term capital gains rate. But you may have reason to sell the shares you bought most recently—last in, first out, or LIFO—if you just bought shares and the stock tumbled, allowing you to take a capital loss, for example. You can also specify certain shares to sell, or just assume you’ll use the average cost per share when figuring your basis.
Mutual fund companies will generally give you information on your fund’s average cost per share. If you use the average cost per share to account for part of a position that you’ve sold, you’ll have to use the same method when you sell the rest.
For sales of individual stocks, the IRS will usually assume you sold the shares using FIFO. If you choose another method, you must tell your broker in writing, and keep a record of that order in case the IRS asks about it. Switching too often among different cost methods could mean that a brokerage would be reluctant to guarantee accuracy if the IRS inquires, warns certified public accountant Michael Landsberg, a member of the American Institute of CPAs’ Personal Financial Planning Executive Committee.
Munis, MLPs AND REITs
Taxes on income from bonds (or bond funds) vary by bond type. Corporate bond income is taxed at ordinary income rates; Treasury bond interest is subject to federal taxes, but not state taxes. Municipal bonds, however, are catnip for tax-averse investors. Munis are free from federal taxes. And if you live in the state that issued the bond, you’ve hit the tax-free trifecta: Interest is typically free from federal, state and local taxes. If you own a muni fund that buys bonds from all states, your fund company will let you know what percentage of your interest is free from state and local taxes.
Despite today’s low yields, a muni bond or fund could well be a better choice than a comparable taxable I.O.U. Before you can decide, however, you’ll need to compare the muni yield to a tax-equivalent yield. For example, Vanguard Intermediate-Term Tax-Exempt (symbol VWITX) has a yield of 2.26%. In order to get the same yield after taxes, a person in the 37% tax bracket would have to earn 3.59% from a taxable alternative and would likely take on much more risk to do so. To figure the tax-equivalent yield, first, subtract your tax bracket as a decimal from 1. Then divide the tax-free yield by that result. In this case, you’d divide 2.26 by 0.63 (or 1 minus 0.37) to get 3.59%.
In a single-state tax-free fund, the rewards can be even richer. Vanguard California Intermediate-Term Tax-Exempt (VCAIX), for instance, yields 2.09%. If you pay the maximum 13.3% California state tax rate and the 37% federal tax rate, your combined tax rate is 50.3%. In this case, your tax-equivalent yield would be 4.24%.
Savers don’t have many good tax-free options. Yields on municipal money market funds are so low that you could be better off in a taxable fund. Vanguard Municipal Money Market Fund (VMSXX) currently yields 1.33%, equivalent to a 2.11% taxable yield for those in the 37% tax bracket. The 100 largest taxable money market funds yield an average 2.24%, according to Crane Data.
Most of the dividends paid by real estate investment trusts and master limited partnerships are taxed at ordinary income tax rates. Unlike many corporations, REITs and MLPs generally pass their cash flow directly to investors. Because the money is not taxed at the corporate level, it doesn’t qualify for the more favorable qualified dividend tax treatment.
Under the new tax law, however, investors can deduct 20% of their REIT and MLP income as a qualified business income deduction. To qualify for the full deduction, among other requirements you need taxable income below $315,000 if you file a joint return ($157,500 for all other taxpayers). You can take the deduction even if you don’t itemize. Not all MLP payouts are taxable: You may get payments that are a return of capital, which you don’t owe taxes on. Your MLP’s K-1 tax form will let you know how much of your MLP’s payout is taxable and what tax treatment it ultimately gets.
Many countries withhold taxes on dividends paid to foreigners. If you invest in an international fund, an international stock or an American depositary receipt, the odds are good that box 7 of your 1099-DIV form will include an amount indicating the foreign taxes paid. The Foreign Tax Credit lets you recoup some or all of those taxes.
Every year, you have the choice of taking a deduction for foreign taxes, which reduces your taxable income, or a credit, which reduces your taxes dollar for dollar. The IRS says it’s generally better to take the credit. Use Form 1116 to figure the tax or credit, and enter it on Schedule 3 of Form 1040.
As investments get more complex, so does their tax treatment. Profits from futures trading are generally taxed as 60% long-term capital gains and 40% short-term gains, no matter how long you’ve held the contract (and in futures trading a few days is a long time).
When you buy or sell option contracts on an exchange, the tax rules are the same as for stocks. Profits on options held less than a year, which covers most options, are typically taxed as short-term gains (the same as ordinary income) and losses are short-term capital losses. Income you pocket for selling (called writing) an option to another investor—to buy a stock that you own, say, or to sell you a stock—gets taxed as a short-term gain. Options aren’t easy, tax-wise; if you wade into options, take an adviser with you.
Gold bugs get less-than-golden tax treatment. The IRS treats gold bullion (and silver, platinum and palladium) as a collectible—the same as baseball cards—rather than as an investment, such as stocks or bonds. Long-term gains on collectibles are taxed at 28%. If you invest in an exchange-traded fund that buys and sells precious metals, your gains will also be taxed at the 28% rate. Funds and ETFs that invest in gold-mining stocks, however, get the same capital gains treatment as any stock fund.
Never let the tax tail wag the investment dog. Maximizing gains should be your priority. Still, it never hurts to reduce your tax bill. Sometime in the fall, check your portfolio to see whether you have some big losers you can sell to generate capital losses that will reduce the tax bill on your gains. If you still love the stock or fund, you can repurchase it after 30 days. (Note that if you don’t wait that long, you’ll have what’s termed a wash sale, and the IRS will disallow your capital loss.)
You may receive a capital gains distribution from your mutual fund, reflecting securities it sold over the year (even though you didn’t sell anything). If you own a fund that consistently doles out big capital gains payouts, consider investing in an index fund. Vanguard 500 Index (symbol VFIAX), for one, hasn’t paid a cent in capital gains since 1999 (it has paid dividend distributions).
You might also consider a tax-efficient fund, which attempts to limit both capital gains distributions and dividend distributions. T. Rowe Price Tax-Efficient Equity Fund (PREFX) strives for above-average after-tax returns—and gets them. The fund has averaged a 16.87% annual gain over the 10 years that ended February 15, beating 80% of large-company growth funds.