Beyond fees and transaction costs, most all investments are subject to taxation – and this represents more expenses for you that can reduce your net return. Let’s see what’s taxed and when. By understanding how different investments are taxed, you are able to do tax planning and thereby maintain money that others pay to IRS.
The federal government taxes you on both income and capital gains. Stocks, bonds and mutual funds symbolize the vast majority of investments retirees have.
Stock and bond tax planning:
When you purchase and hold an individual stock or bond, you must pay income tax every year on dividends or interest you get. Most dividends are taxed at 15% but not all. Therefore use some tax planning to make sure that your stocks generate ‘qualifying’ dividends. But you will not need to pay any capital gains tax till you sell a security. And of course, a profit indicates you sold your stock or bond for more than you purchased it for – or else it is a capital loss (and deductible within limits). Once again, some tax planning might assist some people reduce the capital gains rate from the regular 15% to possibly zero capital gains tax.
Mutual fund tax planning:
Once you purchase and hold mutual fund shares, you’ll owe income tax on any ordinary dividends you get during the year- whether you actually receive them or automatically reinvest them. Sound tax planning tells you to by no means buy mutual funds near the end of the year otherwise you will be subject to taxes on all the fund’s income accumulation for the whole year.
You incur capital gains 2 ways. If you sell your mutual funds for more than you bought them, you will have a capital gain – otherwise a capital loss.
But you may also need to pay taxes every year on the fund’s own capital gains arising from the fund selling its underlying securities. The fund passes these profits on to you as ‘distributed’ capital profits in proportion to the shares you on in the fund. Tax planning specialists suggest purchasing index funds simply because all the gains will be long-term and taxed at reduced rates (currently 15% or less) than gains from the typical growth fund (which tend to generate a lot of short term and highly taxed gains).
Tax Free Funds Tax Planning:
In the event you make investments in a tax-exempt mutual fund – such as a municipal bond fund – some (or all) of your fund returns will be exempt from federal (and occasionally state and local) income tax since they arise from interest income from the underlying tax-free securities.
However you may nonetheless owe capital gains tax on the fund’s distributed gains if the fund sold bonds during the year for a profit.
And, needless to say, you’ll owe personal capital gain tax once you sell your tax-exempt fund shares for more than you purchased them. Tax planning specialists frequently suggest buying individual municipal bonds and hold to maturity and thereby eliminate any tax impact that you cannot control when you own tax free funds.
Capital Gains Tax Planning
Remember, capital gain taxation happens at special capital gain income tax rates. These are lower than ordinary income tax rates. The capital gain tax rates that apply to you depend on what income bracket you are in (see table beneath). Taking gains at the right time is the type of tax planning done by smart traders as your tax bracket affects just how much capital gains you pay.
| Tax Planning of Capital Gains |
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| Capital asset | Holding period | Tax rate |
| Short-term capital gain | 1 year or less | Ordinary income tax rate |
| Long-term capital gain | More than 1 year | 0% for qualifying dividends if you’re in the 10% or 15% income tax bracket
15% for qualifying dividends if you’re in the 25% or higher income tax bracket |
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