Why “Safe Harbors” Can Be Risky Business
Written by Jason Hiley
Written by Andrew Hunt
Tax season is in full swing, and we wanted to give an overview of what to expect when it comes to investment taxes. Taxes are ever-changing and can have a significant impact on your net returns. Detailed tax rules for dividends are on the IRS website. We always encourage you to consult a tax advisor for the most comprehensive and up-to-date tax information, but here is an overview of investment tax basics.
Let’s assume you buy some stock for a low price and after a certain period of time, the value of that stock has increased substantially. You decide you want to sell your stock and capitalize on the rise in value. The profit you make when you sell your stock is equal to your capital gain on the sale.
The IRS taxes capital gains at the federal level and some states also tax capital gains at the state level. The tax rate you pay on your capital gains depends in part on how long you hold the asset before selling.
There are short-term capital gains and long-term capital gains and each is taxed at different rates. Short-term capital gains are gains you make from selling assets that you hold for one year or less. They’re taxed like regular income. That means you pay the same tax rates you pay on federal income tax. Long-term capital gains are gains on assets you hold for more than one year. They’re taxed at lower rates than short-term capital gains.
Most interest income is taxable as ordinary income on your federal tax return and is, therefore, subject to ordinary income tax rates. Generally speaking, most interest is considered taxable at the time you receive it or can withdraw it.
One exception is interest on bonds issued by U.S. states and municipalities, most of which are exempt from federal income tax. Investors may get a break from state income taxes on interest as well. U.S. Treasury securities, for example, are exempt from state income taxes, while most states do not tax interest on municipal bonds issued by in-state entities.
Investors can minimize their capital gains tax liability by harvesting tax losses. If one or more stocks in a portfolio drop below an investor’s cost basis, the investor can sell and realize a capital loss for tax purposes. Investors may offset capital gains against capital losses acquired either in the same tax year or carried forward from previous years. Individuals may also deduct up to $3,000 of net capital losses against other taxable income each year. Any losses in excess of the allowance can be used to offset gains in future years.
But there’s a catch. The IRS treats the sale and repurchase of a “substantially identical” security within 30 days as a “wash sale,” for which the capital loss is not allowed in the current tax year. The loss increases the tax basis of the new position instead, deferring the tax consequence until the stock is sold in a transaction that isn’t a wash sale.
Companies pay dividends out of after-tax profits. That’s why shareholders get a break, a preferential maximum tax rate of 20% on “qualified dividends” if the company is domiciled in the U.S. or in a country that has a double-taxation treaty with the U.S. acceptable to the IRS.
Non-qualified dividends paid by other foreign companies or entities that receive non-qualified income are taxed at regular income tax rates, which are typically higher.
People get excited and eager to learn about investing and investment strategies, but don’t have quite the same interest when it comes to understanding investment taxes. For this reason alone, we encourage you to work with a trusted tax advisor and wealth management advisor. Part of a successful financial plan is astute tax management. When you work with us, we can refer you to experienced tax advisors that can round out your financial strategy and ensure you are getting the most out of your investments. Set up an introductory meeting with us to see how we can help you on your investment journey.