What You Should Know About Taxation of Investments
By Laurie Haelen
If you are trying to accumulate wealth for your life goals, it is likely that you own stocks, bonds and other investments.
The income and growth provided by investment vehicles are great — until it’s time to file your federal income tax return.
How are investment returns reported and how are they taxed? Even if you use a tax professional, it is a question worth asking and a concept that is useful to comprehend, especially as we approach tax season.
To determine how an investment vehicle is taxed in a given year, first ask yourself what went on with the investment that year. Did it generate interest income? If so, the income is probably considered ordinary. Did you sell the investment? If so, a capital gain or loss is probably involved.
If you receive dividend income, it may be taxed either at ordinary income tax rates or at the rates that apply to long-term capital gain income.
Dividends paid to an individual shareholder from a domestic corporation or qualified foreign corporation are generally taxed at the same rates that apply to long-term capital gains. Long-term capital gains and qualified dividends are generally taxed at special capital gains tax rates of 0%, 15% and 20% depending on your taxable income. (Some types of capital gains may be taxed as high as 25% or 28%.)
The actual process of calculating tax on long-term capital gains and qualified dividends is extremely complicated and depends on the amount of your net capital gains and qualified dividends and your taxable income.
The distinction between ordinary income and capital gain income is important because different tax rates may apply and different reporting procedures may be involved.
Here are some of the things you need to know.
Investments often produce ordinary income, such as interest and rent. Many investments — including savings accounts, certificates of deposit, money market accounts, annuities, bonds and some preferred stock — can generate ordinary income. Ordinary income is taxed at ordinary (as opposed to capital gains) tax rates.
But not all ordinary income is taxable — and even if it is taxable, it may not be taxed immediately. If you receive ordinary income, the income can be categorized as taxable, tax exempt or tax deferred.
• Taxable income: This is income that’s not tax exempt or tax deferred. If you receive ordinary taxable income from your investments, you’ll report it on your federal income tax return. In some cases, you may have to detail your investments and income on Schedule B.
• Tax-exempt income: This is income that’s free from federal or state income tax, depending on the type of investment vehicle and the state of issue. Municipal bonds and U.S. securities are typical examples of investments that can generate tax-exempt income.
• Tax-deferred income: This is income whose taxation is postponed until some point in the future. For example, with a 401(k) retirement plan, earnings are reinvested and taxed only when you take money out of the plan. The income earned in the 401(k) plan is tax deferred.
Let’s move on to what happens when you sell an investment vehicle. Before getting into capital gains and losses, though, you need to understand an important term — basis. Generally speaking, basis refers to the amount of your investment in an asset. To calculate the capital gain or loss when you sell or exchange an asset, you must know how to determine both your initial basis and adjusted basis in the asset.
Usually, your initial basis equals your cost — what you paid for the asset. For example, if you purchased one share of stock for $10,000, your initial basis in the stock is $10,000. However, your initial basis can differ from the cost if you did not purchase an asset but rather received it as a gift or inheritance or in a tax-free exchange.
Adjusted basis is a bit more complicated. Your initial basis in an asset can increase or decrease over time in certain circumstances. For example, if you buy a house for $100,000, your initial basis in the house will be $100,000. If you later improve your home by installing a $5,000 deck, your adjusted basis in the house may be $105,000. You should be aware of which items increase the basis of your asset and which items decrease the basis of your asset. See IRS Publication 551 for details.
If you sell stocks, bonds or other capital assets, you’ll end up with a capital gain or loss. Special capital gains tax rates may apply. These rates may be lower than ordinary income tax rates.
Basically, capital gain (or loss) equals the amount that you realize on the sale of your asset (i.e., the amount of cash or the value of any property you receive) less your adjusted basis in the asset
Schedule D of your income tax return is where you’ll calculate your short-term and long-term capital gains and losses, and figure the tax due, if any. You’ll need to know not only your adjusted basis and the amount realized from each sale, but also your holding period, your taxable income and the type of asset(s) involved. See IRS Publication 544 for details.
• Holding period: Generally, the holding period refers to how long you owned an asset. A capital gain is classified as short term if the asset was held for a year or less and long term if the asset was held for more than one year.
• Taxable income: Long-term capital gains and qualified dividends are generally taxed at special capital gains tax rates of 0%, 15% and 20% depending on your taxable income. (Some types of capital gains may be taxed as high as 25% or 28%.)
• Type of asset: The type of asset that you sell will dictate the capital gain rate that applies and possibly the steps that you should take to calculate the capital gain (or loss). For instance, the sale of an antique is taxed at the maximum tax rate of 28% even if you held the antique for more than 12 months.
You can use capital losses from one investment to reduce the capital gains from other investments. You can also use a capital loss against up to $3,000 of ordinary income this year ($1,500 for married persons filing separately). Losses not used this year can offset future capital gains. Schedule D of your federal income tax return can lead you through this process.
The sales of some assets are more difficult to calculate and report than others, so you may need to consult an IRS publication or other tax references to properly calculate your capital gain or loss. Given the complexity of tax codes and all that I have described, remember that you can always seek the assistance of an accountant or another financial professional.
Laurie Haelen, AIF (accredited investment fiduciary), is senior vice president, manager of investment and financial planning solutions, CNB Wealth Management, Canandaigua National Bank & Trust Company. She can be reached at 585-419-0670, ext. 41970 or by email at lhaelen@cnbank.com.