Every year I get a lot of questions about how investment accounts impact taxes. One thing to address right off the bat is that retirement accounts, like an IRA or a 401(k), have totally different rules and generally the activity inside one of those accounts has no impact on your taxes.
Taxes are not the only, or even the most important, factor to consider when investing. It can be tempting to make investment decisions based on how things are going to go on tax day, but it is important to take a holistic view. If I choose to invest in something simply because it is better for my taxes but receive worse investment returns, I may save money on tax day, but I also have a smaller investment account than I would otherwise.
Please note that this post contains general information, and it should not be construed as investment advice.
Interest
Tax-Exempt Interest vs Taxable Interest
Investing in municipal bonds, often called "muni bonds" or "munis," is a common strategy to earn interest that is tax-free. This also includes mutual funds or ETFs invested in munis. This interest is exempt from tax at the federal level, but each state has its own rules about what municipal bond interest is taxable. For example, I live in Ohio, where interest on bonds issued in Ohio or US territories is tax-exempt, but interest on bonds issued in any of the other 49 US states is taxable. Some states are buddies that give reciprocal tax-exempt status, and some states even tax interest on their own bonds!
Generally, all other types of interest are taxable, which could include corporate bonds, CDs, or interest from a checking account or money market account. These items are taxed at your regular tax rate.
Dividends
Qualified Dividends vs Ordinary Dividends
Ordinary dividends do not receive preferential tax treatment, so they are taxed at the same rate as other income. If certain criteria are met, a dividend can be classified as qualified. Qualified dividends are eligible to be taxed at the lower capital gains tax rates. The three criteria are:
The dividends must have been paid by a US corporation or a qualified foreign corporation. A foreign corporation is qualified if (a) it is incorporated in a US possession, (b) it is eligible for the benefits of a comprehensive income tax treaty, or (c) its stock is readily tradable on an established securities market in the US. However, passive foreign investment companies are specifically excluded from being a qualified foreign corporation.
The dividends are not the type specifically excluded by the IRS. Certain distributions cannot be classified as qualified dividends, such as capital gain distributions, dividends that are really interest, such as "dividends" paid from a credit union (instead, these "dividends" are reported as interest), tax-exempt or farmer's co-op dividends, dividends on stock held in an employee stock ownership plan, etc. Special dividends, or one-time payments, cannot be classified as qualified dividends.
You meet the holding period. You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (sometimes called "ex-date" for short). When counting, the day you sell is included, but the day you buy is not.
Given this, what should you do to ensure you receive qualified dividends? For the average investor, the answer is nothing. Most regular dividends are going to be qualified so long as you are a long-term investor and meet the holding period requirement.
Dividend Reinvestment
One common point of confusion for investors come tax time is the role of dividend reinvestment. The answer is that a reinvested dividend is still a dividend, and you must pay tax on it. For example, let's say I own a mutual fund where I receive a $100 dividend that is immediately reinvested. After that dividend is paid, I do not have $100 in cash, but the value of my mutual fund investment has gone up by that $100. It may be helpful to think of it as two separate transactions, where I receive $100 cash and choose to use that cash to purchase $100 of the same mutual fund. I received the $100 dividend, so it is still taxable to me, even though I chose to reinvest it.
Capital Gains/Losses
At its most basic, a capital gain or loss is simply the difference between the sale price and the purchase price of a security. Let's say I buy a share of stock for $100. If I later sell that share for $125, I have a realized capital gain of $25. If I instead sell that share for $80, I have a realized capital loss of $20. Every time a security is sold, there will be capital gain or loss, even if you immediately invest into another security. This includes a mutual fund exchange, which is considered a separate sale and purchase, not a single transaction.
The biggest factor in determining the tax treatment of capital gains and losses is the holding period. Investments held for more than one year are classified as long-term, and those held for one year or less are classified as short-term. The holding period begins the day after the trade date of purchase and ends on the trade date of sale.
When you have purchased the same security multiple times it may be unclear when you sell shares if you have a gain or loss and if your holding period is long-term or short-term. In this case, the assumption is that the first shares purchased are the first shares sold. This is known as FIFO (first in, first out). It is also possible to tell your broker that you would like to sell specific shares rather than simply selling the oldest. This is known as specific share identification.
What if I have a net loss?
If the net of all gains and losses for the year is an overall loss, some or all of that can be deducted from other income on your tax return. The annual limit to deduct is $3,000, or $1,500 if married filing separately. If the amount of the net loss is greater than this limit, the remainder can be carried forward indefinitely to offset future gains.
Example:
Philippe has a net capital loss of $5,500 in year 1. He can deduct $3,000, and the remaining $2,500 carries forward into year 2. In year 2, Philippe has a net capital loss of $2,200. He adds the $2,500 carried forward from year 1 to get a total net capital loss of $4,700 for the year. He deducts $3,000, and the remaining $1,700 carries forward into year 3. In year 3, he has a net capital gain of $2,000. Philippe subtracts the loss carryforward of $1,700, and he only has to include $300 of net capital gain on year 3.
What if I have a net gain?
If the net of all gains and losses for the year is an overall gain, it will be added to income. Short-term gain is treated as ordinary income and taxed at the regular rate. Long-term gain has a preferential capital gains tax rate of 0%, 15%, or 20%. The 0% capital gains rate roughly corresponds to the lowest two regular tax brackets (10% and 12%), the 20% capital gains rate roughly corresponds to the highest regular tax bracket (37%), and the 15% capital gains rate applies for everyone in the middle.
Wondering what your tax bracket is? Check out the current rates on Bankrate. Just remember that the tax bracket is based on taxable income, not gross income, so all deductions have already been subtracted. At most your taxable income would be your gross income less the standard deduction. View my previous blog post, Anatomy of a Tax Return, for a refresher.
What is a wash sale? How does that impact gains and losses?
A wash sale happens when you sell a security at a loss and you buy a "substantially identical" security within 30 days before or after. In this event, the loss resulting from the wash sale is disallowed. The reason for this is to prevent people from artificially creating deductible losses and immediately reinvesting in a security.
Example:
Philippe purchases 10 shares for $100 on April 1, year 1. On December 15, year 1, he decides to sell those shares for $80, which is a loss of $20. The stock begins to rebound in January, and Philippe purchases 10 shares on January 5, year 2, for $90. Later in year 2, Philippe sells the 10 shares on May 15 for $105.
When filing taxes for year 1, does Philippe get to claim the loss of $20? No. Because he repurchased the shares within 30 days, it is considered a wash sale, and the entire loss is disallowed.
When filing taxes for year 2, what does Philippe have? Gain/loss? Short-/long-term? He has a long-term loss of $5. The disallowed loss of $20 from year 1 is added to the cost basis of $90 for a new cost basis of $110. When he sold for $105, it is a loss of $5. His total holding period is the total from both times he held the stock from April 1 to December 15, year 1, and January 5 to May 15, year 2, which is just shy of 13 months.
An easy way to visualize this is to add together the total spent on purchases, which was $190, and subtract the total made from sales, which was $185. This leaves a loss of $5 between all the transactions.
This next illustration shows how the math works mechanically from the IRS's perspective and how the disallowed loss is added to the new cost basis.
Another thing to keep in mind is that wash sales do not have to happen in the same account. For example, if you sell a security for a loss in a normal brokerage account and purchase it within 30 days in an IRA it is still considered a wash sale. The loss would be disallowed, and this would also affect your basis in your IRA.
How is this information reported to me?
Most investors work with a brokerage company (like Fidelity, Merrill Lynch, E-Trade, etc.), which will provide 1099-series forms at the end of the year. Technically, there are separate forms for each of the areas we have discussed. Interest is reported on 1099-INT, dividends on 1099-DIV, and sales of securities on 1099-B. However, in practice, most brokerage companies will send what they call a consolidated 1099 that contains all the relevant information in one document.
Forms 1099-INT and 1099-DIV must be filed any time the bank or brokerage pays you $10 or more in interest or dividends, respectively. Form 1099-B must be filed for any brokerage transaction. If you receive a 1099 the IRS also receives a copy, which means you must make sure it is included as part of your tax return. Failing to include information from a 1099 on your return is a big red flag to the IRS, even if it is a small dollar amount. Sometimes you may get a "de minimis" consolidated 1099 from your brokerage for an account that did not have activity that rose to the level of requiring reporting. This means it was not filed with the IRS and you do not need to include it on your return.
Want to learn more about tax basics? Sign up for my newsletter to get posts like this directly in your inbox!
What other types of posts would you like to see? Reach out to me at kyle@kylenortoncpa.com or comment below and let me know!