With a few exceptions, most of your investments are either going to be taxed as ordinary income or capital gains

Ordinary income

You should be familiar with the ordinary income tax rates. Your salary or pass-through business income is subject to this tax rate.

Many investments are also subject to this tax rate, including interest, non-qualified dividends, and short-term capital gains of stock sold but held less than one year.

Likewise, all distributions (withdrawals) from your traditional tax-advantaged accounts, such as an IRA or 401K, come out taxed as ordinary income.

This can be confusing as you most likely had stock funds and bond funds within those tax-advantaged accounts. Those funds were paying interest and dividends that were reinvested. Likewise, many stocks were bought and sold within funds, generating capital gains, that were also reinvested.

As it would be an administrative nightmare to keep track of decades worth of transactions, the IRS has made it simple: it’s all taxed as ordinary income.

Capital gains

Capital gains rates will never be more than your ordinary income tax rates. Most of the time they are taxed at a much lower rate.

• Those of you in the 10% or 12% ordinary income tax bracket, will pay zero capital gains tax. Taxable income less than $40,000 (single, 2020) or $80,000 (married filing jointly).
• Most of you, who land in the 22% to 35% ordinary income tax bracket, will pay only 15% capital gains tax
• You won’t get hit with the 20% capital gains bracket until your taxable income is over $441,450 (single, 2020) or $496,600 (MFJ)

The two things that get this special capital gains rate are qualified dividends and stock (or stock funds) sold after being held for more than 1 year.

Remember you aren’t taxed on your stock gains until you sell the stock. You could hold onto an individual stock for years, watching as it rises in price, and pay no taxes.

Photo by James McGill on Unsplash

Qualified Dividends

When a company earns money, they pay taxes on that money. Sometimes they choose to share a portion of those earnings with their shareholders in the form of a dividend. The shareholders then pay taxes on those dividends. This dividend money was taxed twice.

In most cases, the IRS avoids double taxation, but dividends are an exception. To partially make up for this, dividends get the special capital gains tax rate.

But not all dividends. To be qualified:

• The dividend must be paid by a US corporation or qualified foreign corporation
• The holding period must be met

To meet the holding period, you must own the stock for at least 60 days before the ex-dividend date plus another 60 days after the ex-dividend date. Or more than 121 days in total, with the ex-dividend date in the middle.

The ex-dividend date is important as it determines who gets a dividend. You must purchase the stock before the ex-dividend date in order to get the dividend in the first place.

All other dividends are referred to as ordinary dividends and are taxed at the usual ordinary income tax rates.

All of this will be reported appropriately on your 1099-DIV form that you receive from your brokerage account, so no need to keep track.

Choosing a tax-efficient fund

Unlike an individual stock that you may hold, stock funds are run by managers that may be turning over stock within the larger portfolio. This generates both long-term and short-term capital gains that will be passed on to you, the investor.

Likewise, any interest or dividends generated by the fund will also be passed on to you and taxed accordingly.

Even if you choose to reinvest these gains, if your fund is within a taxable account, such as a brokerage account, you’ll be taxed.

Depending on how often turnover and other distributions occurs will determine the “tax efficiency” of the fund.

Given a choice, it’s best to keep your “tax-efficient” funds in your brokerage account and leave your “inefficient” funds in your tax-advantaged accounts where it doesn’t matter.

Anything that generates income is “inefficient” including bond funds and dividend-producing stock funds. Growth funds are usually more tax-efficient as few dividends are paid.

To determine this, dive deeper into the “performance” tab listed with your favorite fund online. You will find a return “before taxes (pre-tax)” and a return “after taxes on distribution (post tax)”. The closer these two percentages match, the more tax-efficient the fund.

Photo by Jennifer Murray from Pexels

To compare different funds, determine the tax efficiency by dividing the “post” value by the “pre” value.

Below are some examples of popular index exchange-traded funds (ETFs)

[flip your phone sideways for easier viewing]

All values are from Fidelity.com, accessed 9/1/2019, based on three-year market returns. Per Fidelity, the highest tax bracket is assumed for the post-tax returns.

Note how the S&P500 is relatively tax-efficient, while the bond funds shown are not.

This assumes that you are following a typical “buy, hold, and rebalance” strategy where most of the time you aren’t selling any funds. Obviously, any selling, including the bit you do for rebalancing, will incur additional capital gains taxes not reflected in the numbers above.

Municipal bonds and other exceptions

If you must hold bonds in a taxable account, a good approach may be to invest in municipal bonds. These bonds are not taxed at the federal level.

If the municipal bonds are from your state, you’ll avoid state taxes as well.

Note that “private issue” municipal bonds may still cost you additional Alternative Minimum Taxes (AMT), so beware.

Because of their tax advantage, “munis” usually pay a lower yield than regular bonds. If you’re in the top tax bracket, they may be the way to go, but otherwise regular bonds may be better.

• Regular bond return x (1 – your tax rate) = after-tax return

You’re comparing a bond fund that pays 4%, to a California Municipal Bond Fund that pays 2%. Let’s say you’re in the 24% tax bracket. 4 x (1-0.24) = 3.04. The bond fund is a better deal with an after-tax return of 3.04%, compared to the return of the muni at only 2%.

Another tax exception: treasuries are never taxed at the state level.

What to do with capital losses

Ok, maybe it was a bad year. You made a few, er, bad investment decisions and now you have a loss. Or more.

First, all short-term gains are offset by short-term losses; and long-term gains are offset by long-term losses. Whatever is left over is offset by the other to get your net gain or loss.

If you have $10K in long-term gains and $20K in short-term losses, you have a net of $10K of losses (10 minus 20).

What do you do with these losses?

The IRS will let you write off, or subtract, up to $3000 from your income in any given year for capital losses.

The rest—$7K in our example—will need to be carried over to next year.

Next year you can either 1) offset it with up to $7K in gains, or if you can’t offset it all, 2) write-off another $3000. If you have more losses next year, you can carry the remaining $4K (plus your new losses) forward forever…

Good luck!

Additional Reading

• Beyond Index Funds: Why Buy Actively Managed (Sometimes). How to pick a fund that aligns with your values and investing style.

• Index Fund Investing for Beginners. Get started saving for your long-term financial goals

• Buy and Hold? Or Active Management? Navigating your life savings through stormy markets

First photo credit: Jamie McInall from Pexels

This information has been provided for educational purposes only and should not be considered financial advice. Any opinions expressed are my own and may not be appropriate in all cases. All efforts have been made to provide accurate information; however, mistakes happen, and laws change; information may not be accurate at the time you read this. Links are included for reference but should not be considered an implied endorsement of these organizations or their products. Please seek out a licensed professional for current advice specific to your situation.