Investing & Taxes

As an investor, you pay income taxes and capital gains taxes on your investments. How much you owe depends on how the income is earned. You owe income taxes on interest earned on bonds. You also pay income taxes on dividends earned on stocks and mutual funds.

You may earn income from investments as diverse as precious metals, business partnerships, or collectibles. However, this topic focuses on taxation of stocks, bonds, and mutual funds.

Generally, if you sell a security at a higher price than you paid, you earn a capital gain. If you sell at a lower price than you paid, you have a capital loss. The length of time that you hold your investment, or holding period, determines whether you have a long- or short-term capital gain or loss. If you hold a security for more than one year (i.e., 366 days), it is considered a long-term capital gain. Short-term capital gains are those that you earn on sales of securities held one year or less.

Long-term capital gains are taxed at a lower rate than your regular income. For all but the lowest income tax bracket, investors pay a long-term capital gains tax rate of 15%. In 2008, investors in the 10 or 15% tax bracket pay a long-term rate of 0%. Short-term capital gains are taxed as regular income. Capital gains are calculated by subtracting the basis from the price for which you sell the investment.

What kinds of income do stocks, bonds, and mutual funds generate, and how is this income taxed?

Taxation on stocks. Stocks generate taxable income as dividends and capital gains which are both taxed at the same favorable rate. Generally, growth stocks don't pay dividends. Instead, they create wealth through a rise in their share prices. Income stocks, on the other hand, generate regular dividend income. Most stocks fall in between growth and income categories.

Taxation on bonds. Bonds are sometimes called fixed-income securities. This is because most bonds have a fixed coupon rate. As a result, interest income is usually a constant amount over the bond term. Bonds also generate capital gains. Investors that buy a bond at a discount and hold it to maturity face a capital gain. Investors that buy a bond at a premium and hold it to maturity face a capital loss.

Taxation on mutual funds. With mutual funds, taxes are more complicated. You buy and sell shares of most mutual funds at the fund's net asset value, or NAV. (Unless you're buying a closed-end mutual fund, in which case you often pay a discount or premium.) You pay taxes on three components: short-term capital gains, long-term capital gains, and dividends.

Two factors have significant tax implications for mutual fund investors. One is the timing of buying fund shares. A fund manager buys and sells securities in the fund's portfolio when it's necessary to buy back shares from existing shareholders or to lock in a profit. Mutual funds are required to pass these dividends and capital gains on to shareholders at least once a year. This usually occurs in the last quarter of the calendar year. When you buy a mutual fund's shares, you may also be subject to capital gains tax for capital gains paid to other shareholders, even if you only recently purchased the shares. To avoid being stuck with a capital-gains tax bill on gains you didn't receive, you may wish to buy shares of a fund after it has made a capital gains distribution. The fund will disclose whether it has or has not yet made distributions for the current year.

The second factor is a fund's tax efficiency. Looking at a fund's tax efficiency can help you to see if the investment manager is making buy-and-sell decisions that minimize your tax bill. One way of evaluating a fund's efficiency is to look at its portfolio turnover ratio. A higher turnover ratio means the fund trades its portfolio more often, incurring more capital gains. A portfolio turnover ratio of 100% means that, on average, the fund trades every security in its portfolio once a year.

To help you pick funds that generate less in capital gains, you may want to consider evaluating a fund's after-tax rate of return. As of February 2002, the SEC requires all mutual funds to report after-tax returns. Initially, funds are only required to report after-tax returns for the highest income tax bracket.

Investing has other tax rules, including:

The "wash-sale" rule. The "wash-sale" rule is aimed at preventing investors from selling a security to lock in a capital loss, immediately buying it back at a lower price. The IRS prohibits you from using the capital losses to offset capital gains if you buy back the same security within 30 days. Instead, you may wish to buy a security with a similar investment objective or similar risk characteristics to the one you sold.

Offsetting capital gains with losses. The IRS allows you to offset your capital gains with capital losses. If your losses exceed your gains, you can offset up to $3,000 of your regular income in a year. For larger amounts of capital losses, you can carry them forward to future years. This is called the capital loss carryover rule.

Some additional ways to reduce your taxes from investing include:

Investing in a tax-advantaged account. A tax-advantaged account allows you to defer taxes on your investments until you take money out of the account. In the case of a Roth IRA, you can avoid taxes on your earnings if you keep the account open for at least five years and don't take out money before age 59-1/2.

Staying abreast of inflation. Inflation is a hidden tax that erodes the value of your investment. Inflation in the U.S. over the last 10 years has been relatively tame, averaging less than 3% per year. However, even this amount, over several years, starts to cut into your returns. To adjust for inflation, you can subtract the yearly percentage rate from your return. This is a good approximation. For example, if a stock returns 9% when inflation is at 3%, the inflation-adjusted rate of return is 6%.

One way to hedge against inflation is to buy Treasury Inflation-Protected Securities, or TIPs. These are government bonds that pay a fixed rate of return. Each year, the U.S. Treasury adjusts the principal amount based on a rate that equals the consumer price index. For example, after the first year, a $1,000 TIP would be adjusted to a new maturity value of $1,030. As a result of the larger principal, your coupon payment would also be larger.

Invest in muni bonds and their mutual funds. The interest that you earn on municipal bonds, muni bond funds, and some tax-exempt money market mutual funds is exempt from federal income taxes. Interest income earned on muni bonds is often exempt from state income taxes for investors who are residents of the state issuing the bonds.

To calculate a muni bond's taxable-equivalent yield, divide the tax-exempt yield by a factor of 1 minus your tax bracket. For example, if you are in the 25% tax bracket, this factor is 0.75. A taxable-equivalent yield on a tax-exempt fund that yields 4.5% is 6%.

Choose investments that don't generate dividends. Most notably, these include growth stocks and the mutual funds that invest in them. Also, you should remember that zero-coupon bonds don't pay coupon interest. However, the IRS requires you to report the amount of imputed interest as taxable income. You can avoid this tax liability by investing in zero-coupon bonds with a tax-advantaged account.

Taxes on your investments are complicated and often unique to your situation. This topic aims at identifying some of the major tax consequences of investing. You may wish to consult a financial or tax adviser before making any investment decisions.