Tax Basics for Investors

Investors need to understand that the federal government taxes not only investment income—dividends, interest, and rent on real estate—but also realized capital gains.

Tax on Dividends

Companies pay dividends out of after-tax profits, which means the taxman has already taken a cut. 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 (a dividend paid from interest on bonds held by a mutual fund, for instance) are taxed at regular income tax rates, which are typically higher.

Shareholders benefit from the preferential tax rate only if they have held shares for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date, according to the Internal Revenue Service.

In addition, any days on which the shareholder's risk of loss is diminished (through a put option, a sale of the same stock short against the box, or the sale of most in-the-money call options, for example) do not count toward the minimum holding period.

For instance, an investor who pays federal income tax at a marginal 35% rate and receives a qualified $500 dividend on a stock owned in a taxable account for several years owes up to $100 in tax. If the dividend is non-qualified or the investor did not meet the minimum holding period, the tax is $175.

Investors can reduce the tax bite if they hold assets, such as foreign stocks and taxable bond mutual funds, in a tax-deferred account like an IRA or 401(k) and keep domestic stocks in their regular brokerage account.

Tax on Interest

The federal government treats most interest as ordinary income subject to tax at whatever marginal rate the investor pays. Even zero-coupon bonds don’t escape: Although investors do not receive any cash until maturity with zero-coupon bonds, they must pay tax on the annual interest accrual on these securities, calculated at the yield to maturity at the date of issuance.

The 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, too. 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 subject to higher tax brackets often prefer to hold municipal bonds rather than other bonds in their taxable accounts. Even though municipalities pay lower nominal interest rates than corporations of equivalent credit quality, the after-tax return to these investors is usually higher on tax-exempt bonds.

Let's say an investor who pays federal income tax at a marginal 32% rate and receives $1,000 semi-annual interest on $40,000 principal amount of a 5% corporate bond owes $320 in tax. If that investor receives $800 interest on $40,000 principal amount of a 4% tax-exempt municipal bond, no federal tax is due, leaving the $800 intact.

Tax on Capital Gains

Investors cannot escape taxes by investing indirectly through mutual funds, exchange-traded funds, real estate investment trusts, or limited partnerships. The tax character of their distributions flows through to investors, who are still liable for tax on capital gains when they sell.

Uncle Sam’s levy on realized capital gains depends on how long an investor held the security. The tax rate on long-term (more than one year) gains is 0%, 15%, or 20% depending on taxable income and filing status. Just like the holding period for qualified dividends, days do not count if the investor has diminished the risk using options or short sales. Short-term (less than one year of valid holding period) capital gains are taxed at regular income tax rates, which are typically higher.

For instance, an investor in the 24% tax bracket sells 100 shares of XYZ stock, purchased at $50 per share, for $80 per share. If they owned the stock more than one year and they fall into the 15% capital gains bracket, the tax owed would be $450 (15% of ($80 - $50) x 100), compared with $720 tax if the holding period is a year or less.

Tax Losses and Wash Sales

Investors can minimize their capital gains tax liability by harvesting tax losses. That is, 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 realized either in the same tax year or carried forward from previous years. Individuals may deduct up to $3,000 of net capital losses against other taxable income each year, too. Any losses in excess of the allowance can be used to offset gains in future years.

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 disallowed 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. A substantially identical security includes the same stock, in-the-money call options, or short put options on the same stock—but not stock in another company in the same industry.

An investor in the 35% tax bracket, for example, sells 100 shares of XYZ stock, purchased at $60 per share, for $40 per share, realizing a $2,000 loss; that investor also sells 100 shares of ABC stock purchased at $30 per share for $100 per share, realizing a $7,000 gain. Tax is owed on the $5,000 net gain. The rate depends on the holding period for ABC—$750 for a long-term gain (if taxed at 15%) or $1,750 for a short-term gain.

If the investor buys back 100 shares of XYZ within 30 days of the original sale, the capital loss on the wash sale is disallowed and the investor owes tax on the full $7,000 gain.

The Bottom Line

Taxes are always changing and can have a significant impact on the net return to investors. Detailed tax rules for dividends—and for capital gains and wash sales—are on the IRS website. Given the complicated nature of these rules, investors should consult their own financial and tax advisors to determine the optimum strategy consistent with their investment objectives and to make sure they are filing their taxes in accordance with regulations.