Investors generally pay close attention to portfolio allocation, performance, strategy and even fees. The impact of taxes, however, is often overlooked when evaluating an investment portfolio.
This blog post will highlight various ways that investors are taxed, including the capital gains tax, capital gain distributions, net investment income tax, and what the difference is between qualified and non-qualified dividends.
There are a few quiz questions along the way so pay attention!
Capital Gains and Losses
When you sell an asset for more than you paid to acquire it (i.e. your cost basis), the government shares in your appreciation. An asset can be a stock, bond, or fund – but also a house, a collectible, a gold bar, home furnishings, etc. Because there are some nuances when selling other assets, this post will focus only on the sale of securities.
If you owned a security for less than one year prior to selling it, any gain in that security’s value (the difference between your purchase price and its sale price) is taxable to you as ordinary income.
However, if your holding period is greater than one year, the investment gains are taxed at long-term capital gains rates. Because the government wants to incentivize long-term investment (rather than “churning” portfolios, with high turnover), these rates are more favorable than ordinary income taxes.
Below are the 2018 federal capital gains tax rates for the three income brackets:
These rules also apply to securities sold below their cost basis – a holding period of less than one year is considered a short-term loss, and longer than one year is a long-term loss. Your holding period is relevant because at the end of each year you net your short-term and your long-term transactions together. If both holding periods result in gains (or both in losses), they are reported separately on Schedule D. However, if one holding period results in a gain and the other in loss, then they are netted against each other.
For example, if Barney realized $5,000 of short-term losses and $1,000 of long-term gains last year, he would report $4,000 of short-term losses on his return. Barney would actually be able to deduct $3,000 of his capital losses against ordinary income on his tax return and he would be able to carry forward the remaining $1,000 (indefinitely) to be used against future capital gains or ordinary income.
Question 1: You sold 4 positions on 12/30/17 and they were your only sales for the year. What is your net realized gain loss for the year, and how much tax, if any, do you owe? Your household income is $250K.
|Stock||Acquired||Cost Basis||Sale Price|
Answer: Net $200 ST loss and net $4,000 LT gain = $3,800 of net LT gain x 15% = $570 in federal CG tax
A majority of states also tax capital gains, but do so at ordinary income tax rates. This map shows the top marginal tax rate on capital gains by state in 2016 (the most recent year for which data has been compiled on this site).
Capital Gain Distributions
Sometimes investors have to pay capital gains tax even though they did not place a trade. These unpleasant surprises occur because mutual funds must distribute at least 95% of the realized gains on the underlying securities within the fund to their shareholders. Actively-managed mutual funds are typically the worst perpetrators as they sell securities more frequently than passive funds. However, indexed mutual funds can distribute capital gains as well if they need to raise cash for redemptions or their benchmark (index) is altered. These distributions can be short-term or long-term gains, but losses are not passed on to investors. However, fund managers are able to carry losses forward to offset future gains within the fund.
Mutual funds announce capital gain distributions ahead of the transaction date, so one way that investors can avoid a capital gain distribution is by selling the fund in advance. For example, if ABC fund announced it will distribute 60% of its NAV as a capital gain before year-end, but your unrealized (built-up) gain in ABC fund was only 3%, you would be wise to sell ABC fund before the distribution record date.
Question 2: Assume you own 2,000 shares of a mutual fund that has one million total shares outstanding. During the year, the mutual fund realized $3 million in total capital gains from the sale of stock positions in its portfolio. Of that total gain, 80% are long-term capital gains and 20% are short-term capital gains. What would the fund distribute to you assuming the fund distributes 100% of their gains?
Answer: $6,000 – LTCG: $3MM *80% *(2k/1MM) = $4,800; STCG: $3MM *20% *(2k/1MM) = $1,200
In contrast, exchanged-traded funds (ETFs) rarely issue capital gain distributions because they are able to handle investment flows by issuing or redeeming “creation units” instead of the underlying securities. A creation unit is a basket of securities packaged as shares of an ETF that the managing company sells to a broker dealer. As an investor you need not worry much about this process, but it is helpful to note that for this reason ETFs tend to be more tax-efficient than mutual funds.
Net Investment Income Tax (NIIT)
The Net Investment Income Tax (colloquially often referred to as the “Obamacare tax”) is a federal 3.8% surtax on investment income for single tax filers with more than $200K of modified adjusted gross income (MAGI), or married tax filers with $250K of MAGI. This tax was enacted in 2013 to generate approximately 50% of the cost of the Affordable Care Act. Net investment income is an intentionally broad term that includes capital gains, dividends, taxable interest, rental income, passive business income, and annuity income.
How it works – if your MAGI without investment income is in excess of the above mentioned levels all of your investment income will be subject to the surtax. However, if your income exceeds the levels only when including investment income, just the dollars above the threshold will be included in the NIIT calculation.
Question 3: Beverly (single) has MAGI of $188k and long-term capital gains $22k – how much will be subject to NIIT?
Answer: $188k + $22k = $210k – $200k = $10k
Each month or quarter, custodians (such as Schwab and Fidelity) report to investors how much dividend income they have received over the given period. Yet, not all dividend payments are created equal! There are qualified dividends and non-qualified dividends, which are often called “ordinary dividends.” Qualified dividends are the preferred income payment as they are taxed at capital gains rates, whereas non-qualified dividends are taxed as ordinary income. In order to be considered “qualified,” dividends must meet the following criteria:
- They must be issued by a U.S. corporation or by a foreign corporation that readily trades on a major U.S. exchange, and
- The investor must hold shares of the issuing security for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date.
Many investors are attracted to higher-yielding investments like REITs, MLPs, BDCs, etc. because of the cash flow they produce. However, all of those investments issue non-qualified dividends, so those investments could potentially be generating twice the tax bill of a US dividend-paying stock ETF. Additionally, most non-equity funds pay out ordinary dividends.
As you can see, whether or not you are investing tax-efficiently can dramatically impact your portfolio’s return over time. Tax should be an element investors consider when evaluating their portfolio and planning opportunities are available. In a forthcoming post I will address asset location which is the process of selecting where investments should be held in a portfolio containing taxable, tax-deferred, and tax-exempt accounts.