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As February has now rolled into March and we begin to focus on the April 15 tax deadline, it’s a good time to look into the role of taxes in investing.  Though only your accountant or lawyer can properly assess the tax consequences of your financial decisions, still, every investor should have a general understanding of how the government taxes investments and should also be aware of which investment strategies have tax advantages beyond those provided by pension funds.  Here are some basic considerations.

Income Tax

 Generally, all income generated from investments –– dividends and interest –– are taxed.  The tax rate, however, can differ considerably from what you pay on ordinary income from wages.  Here are how these rates vary and why:

Interest Payments 

You pay standard income tax rates on almost all interest received from investments, including interest on deposits at banks and other financial institutions and on interest from short-term bills bought and sold on financial markets.  Taxable as well are payments you receive from corporate bonds and from bonds issued by foreign entities (corporations and governments), including interest paid on U.S. Treasury bonds.  Interest paid on Treasury savings bonds is, however, free of state and local income tax.

Tax-Free Bonds

I posted earlier that taxes are excused on payments from municipal bonds (also called muni bonds).  But there are exceptions: income from bonds that support private, profit-making activities is taxed.  This should be clear in the bond’s prospectus and any broker/dealer should so inform you.

Because of their tax advantages, municipal bonds pay a lower yield than equivalent taxable bonds.  In recent years, about a 28 percent personal income tax rate is where the lower yield paid by the average municipal bond balances the advantages of the tax savings on the bond.  Professionals call this the break-even point.  If your income tax rate is higher, the muni bond becomes attractive, because your tax savings will be more than the bond’s lower interest yield. If your personal tax rate is lower than 28 percent, muni bonds become unattractive, because you would be giving up more in yield than what you save in taxes.

Dividend Income

Most dividend income qualifies for a reduced tax rate. This lower rate is usually the same as capital gains tax rates (of which more below).   As of this writing, the top tax rate on capital gains and qualified dividends is roughly half the top rate on ordinary income. To get this tax break, you must have held the stock for at least 60 days and the dividends must be issued from either a U.S. corporation, a company incorporated in the United States or one of its possessions, or a foreign corporation whose stock readily trades on a major U.S. exchange.  Even when dividends meet these criteria, they do not qualify when, among other things, they reflect dividend distributions connected with capital gains realized by the corporation itself, are paid on bank deposits, or are paid by tax-exempt corporations.

The reasoning behind giving dividends a reduced tax rate, as well as for the exceptions to it, is that corporations already pay a separate income tax before paying dividends.  Because that expense counts against –– that is, it’s paid before –– shareholder income, the argument goes, a tax rate on dividend income equal to the tax rate on ordinary income would effectively tax shareholders twice.  Applying a lower rate on dividends tops up the rate already paid at the corporate level to the full individual rate on ordinary income.

Capital Gains Tax

Generally, you are taxed when you realize any gains, the difference between the price you received when you sold the investment and the price you paid when you first bought it.  The tax rate on capital gains is usually lower than the rate on ordinary income. However, the lower rate only applies when you have held the asset for a year or more. Such profits are designated as long-term gains; if less than a year, the gains are considered short-term and are taxed at the rate applied to ordinary income.

Here is a useful strategy to help you minimize your capital gains taxes. Because the law allows taxpayers to write capital losses against capital gains before calculating your tax bill, review all your holdings for securities that have lost value each time you sell one for a profit.  By selling both, you can subtract the realized losses from the gains and pay tax only on the net figure.  This strategy works for both short-term and long-term gains and losses.

If, for sound investment reasons, you want to continue holding the securities sold at a loss, simply buy them back, though IRS rules dictate that you must wait 30 days before repurchasing the securities.  Keep in mind that the clock determining long- and short-term gains on those repurchased assets then resets to the new purchase date.  If these securities then gain in value and you want to sell, you would have to wait a full year for them to qualify for the long-term capital tax gains rate.  Though this strategy increases transactions costs, usually the tax savings more than justify this expense.

Note 1: Never take losses this way that are greater than the gains.  For tax purposes, wait from realizing the losses until you have gains elsewhere to counterbalance with the tax losses.

Note 2: When executing this strategy, be careful to match short-term losses against short-term gains and long-term losses against long-term gains.  To realize the tax advantages, never use short-term losses to offset long-term gains, though it sometimes pays to use long-term losses to offset short-term gains.

Recent Tax Proposals

Periodically, Washington or various state capitals float ideas about new taxes on investments and investment income.  A perennial favorite is the financial transactions tax.  Another, just introduced by Senator and presidential hopeful Elizabeth Warren of Massachusetts, is a federal wealth tax. I offer a word or two on each, taking the most recent proposal first.

The wealth tax would seem to have a dubious future.  It would burden in particular the many who hold wealth that does not produce ready income, and they especially would resist it.  It is also problematic because it would conflict with real estate taxes, which are a form of wealth tax relied on for revenue by states and particularly towns and cities.  It also poses constitutional questions.  Note that the country had to pass a constitutional amendment to enable the federal government to levy income taxes.  (It used such taxes during the emergency of the Civil War, but by the early twentieth century it became apparent that Washington would need, permanently, additional sources of income; thus the Sixteenth amendment, passed in 1913.)  But the amendment’s text speaks only in terms of income, not wealth.  If it took an amendment to enable the federal government to levy income tax, a wealth tax may well require the high hurdle of another amendment.

The idea of a financial transactions tax has arisen periodically in Washington and, obviously, in New York City–home to Wall Street.  Transaction taxes come in all flavors, but generally they are taxes investors pay whenever they buy or sell a stock or bond (usually a small percentage of the value of the transaction).

Transactions taxes have come and gone.  In the United States, the Revenue Act of 1914 imposed a 0.2 percent tax on stock trading.  Washington doubled it to 0.4 percent in 1932 during the Great Depression and kept it there until it was repealed in 1966.  At present thee are no transaction taxes in the U.S., except for a very small percentage on large futures trades. (More on these in this post.  At last count, some 40 countries have transaction taxes, including Belgium, Finland, France, Greece, India, Italy, Japan, Singapore, Sweden, Switzerland, Taiwan, and the United Kingdom.  Their rationale for these taxes — and for when such taxes are proposed in the U.S . –– includes:

  • The taxes supposedly dampen market volatility by discouraging trading.
  • They curb speculation for the same reason.
  • They offer a fairer and more equitable way to collect taxes.
  • They have little susceptibility to evasion.

Seldom mentioned but nonetheless prominent is that transactions taxes would offer a great source of revenue to government.

Attempts to re-impose the tax in the U.S, whether locally or nationally, have foundered on fears that it could prompt trading to move away from the jurisdiction imposing the tax.  The stock exchange has threatened to leave New York City, for instance, whenever the mayor or the governor in Albany has proposed such a tax.  It would take many jobs and much income with it.  Especially in an electronic age, such a move would face little difficulty.  The same argument has forestalled efforts to impose such a tax at the federal level. So much business has already gone offshore in the so-called inversions in which American firms to secure lower tax rates have incorporated in Ireland and other low-tax jurisdictionsthe politicians fear the same for securities dealing and trading. Still, the proposals return from time to time and every investor should keep informed on the issue..