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Investment tax planning can help you maximize after-tax returns on your investments. Tax planning for specific types of investments helps you identify which types of investments are best suited to your unique situation. Because different types of investments produce income or gain that may be taxed differently, you need to know how specific investments attempt to earn money and how those earnings are taxed. You also need to know how to treat any gain or loss when you sell your investments.
How do investments earn money?
Your investments can earn money in two ways: (1) they may generate income (such as dividends, interest, or rent) and/or (2) they may appreciate in value and can potentially be sold at a profit.
How are investment earnings taxed?
Some investment earnings may be tax exempt. Some may be tax deferred. Other earnings may be classified as ordinary income, taxable at ordinary income tax rates. Finally, other earnings may be taxed at the more favorable long-term capital gains tax rates.
Long-term capital gains are generally taxed at capital gains tax rates of 0 percent for taxpayers in the 10 and 15 percent marginal tax rate brackets, 15 percent for taxpayers in the 25 to 35 percent marginal tax rate brackets, and 20 percent for taxpayers in the 39.6 percent marginal tax rate bracket.
Generally, long-term capital gains tax rates are more favorable than ordinary income tax rates. Currently, the highest ordinary income tax bracket is 39.6 percent, while the highest long-term capital gains tax rate (for most types of assets) is 20 percent. That's a difference of 19.6 percent.
Qualified dividends received by an individual shareholder from a domestic corporation (or a qualified foreign corporation) are taxed at long-term capital gains tax rates.
How does this apply to specific investments?
Specific investments and investment vehicles within your portfolio can generate income and earnings that will be taxed in different ways. By looking at the tax ramifications of each, you can estimate the potential total after-tax return on your investments and reallocate assets, if appropriate.
Cash and cash alternatives
Cash and cash alternatives typically include (1) money market deposit accounts, (2) CDs and other term deposits, (3) money market mutual funds, and (4) U.S. Treasury bills. You may have these types of assets in your portfolio because they are liquid and are considered relatively low risk compared to other types of investment vehicles.
Money market funds are neither insured nor guaranteed by the FDIC or any other government agency. Though a money market fund attempts to maintain a $1 per share price, there is no guarantee it will always do so, and it is possible to lose money investing in a money market fund.
These types of investments generally earn regular interest income. Regular interest income is classified as ordinary income and is taxed at ordinary income tax rates in the year it is earned. You may receive such earnings in the form of a cash payment or a credit to your account, or, in the case of a money market mutual fund, you may be able to reinvest the earnings directly back into the fund. These earnings will be reported to you on Form 1099-INT or Form 1099-DIV. You report such income on Schedule B. Investment expenses relating to the income (e.g., annual fees) may be taken as a miscellaneous itemized deduction, subject to the 2 percent limit (reported on Schedule A).
Some money market mutual funds may distribute earnings that represent qualified dividends from corporate stock that are eligible for long-term capital gains tax treatment. You may receive the earnings in the form of a cash payment or you may be able to reinvest the earnings directly back into the fund. Either way, you must report the income in the year it is earned. The fund should report any portion of earnings that represents qualified dividends.
Some earnings generated by money market securities may be tax exempt. Money market mutual funds should report the portion or earnings that is tax exempt.
Money market mutual funds may distribute capital gain earnings derived from the sale or exchange of securities within the fund. The fund must distribute these earnings to shareholders to the extent they are not offset by capital losses. You may receive the earnings in the form of a cash payment or you may be able to reinvest the earnings directly back into the fund. Either way, you must report the income on Schedule D (or directly on Form 1040 if you are reporting capital gain income from distributions only) in the year it is earned.
You may also realize a capital gain (or loss) if you sell or exchange your cash alternative investments. If the capital gain is short-term (the asset was held for one year or less), the income will be taxed at ordinary income tax rates. If the capital gain is long-term (the asset was held for more than one year), the income will be taxed at capital gains tax rates. You may offset capital losses against capital gains (you must follow the netting rules). If you have a net capital loss, you may deduct up to $3,000 ($1,500 if married filing separately) from other income. You may carry forward any excess loss to future tax years until it is all used up (you must use up short-term losses first even if they are incurred after long-term losses). Expenses relating to the capital asset (e.g., commissions, sales fees) are added to the asset's basis (cost).
You may have bonds in your portfolio because they generally carry less risk than stocks and/or because they generate regular income. There are many types of bonds including U.S. government securities, corporate bonds, municipal bonds, agency bonds, mortgage and asset-backed securities, and foreign government bonds. Bonds are debt instruments. They generally pay you regular earnings called dividends, which are really interest, and at maturity you receive the bond's face value.
Some types of bonds generate dividends that are exempt from federal taxation, state taxation, or both, though some tax-exempt bond interest may be subject to the alternative minimum tax. Taxable bond interest will generally be reported to you on Form 1099-DIV.
Expenses relating to bonds are treated the same as expenses relating to cash and cash alternatives (see above). However, if you borrow the money to purchase taxable bonds, interest on the loan can only be deducted to the extent of taxable net investment income. And, if you borrow the money to purchase tax-exempt bonds, interest on the loan is not deductible.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2018.