Owning a diversified portfolio of stocks, bonds, and other investments is a critical part of a well-designed retirement income plan. However, when it is time to complete your federal income tax return you may be left scratching your head. Just how do you report your investments and how are they taxed? And, what can you do to minimize your tax bill?
Is It Ordinary Income or Capital Gain?
One of the terms you will hear us mention often is “Asset Location.” This is a process HCM utilizes to place different types of assets (stocks vs. bonds) in different tax environments (taxable vs. IRA, Roth IRA) to minimize your overall tax burden. To determine how an investment is taxed, first ask yourself what goes on with the investment. Does it generate interest income? If so, the income is probably considered ordinary, and the investment that generates it belongs in a traditional IRA or other tax deferred account. Did you sell the investment? If so, a capital gain or loss may be coming. (Certain investments can generate both ordinary income and capital gain income, but we won't get into that here.)
If you are invested in the HCM Dividend Growth™ portfolio, the qualified dividend income you receive is taxed at preferential rates that apply to long-term capital gain income. When possible, we arrange for this income to be recognized in taxable accounts so that you receive the full benefit of these lower rates. Long-term capital gains as well as qualified dividends are generally taxed at special capital gains tax rates of 0 percent, 15 percent, and 20 percent depending on your taxable income.
The distinction between ordinary income and capital gain income (including qualified dividends) is important because different tax rates apply, and different reporting procedures may be involved. Here are some of the things you need to know.
Categorizing your Income
Investments can produce ordinary income, which is taxed at your highest marginal tax rates. Examples of ordinary investment income include interest, net short-term capital gains, distributions from traditional IRAs, distributions from most employer plans and rent. Many investments — including savings accounts, certificates of deposit, money market accounts, annuities, bonds, and some preferred stock (among others) — can generate ordinary income.
But not all income is taxable — and even if it is taxable, it may not be taxed immediately. Income can be categorized as taxable, tax exempt, or tax deferred.
- Taxable income: This is income that's not tax exempt or tax deferred. If you receive taxable income from your investments, you'll report it on your federal income tax return in the year received.
- Tax-free income: This is income that is free from federal and/or state income tax, depending on the type of investment vehicle and the state of issue. Municipal bonds are a good example of an investment that can generate tax-free income. Roth IRAs provide a tax environment that produces tax-free income.
- Tax-deferred income: This is income whose taxation is postponed until some point in the future. For example, with traditional IRAs and 401(k) retirement plans, earnings are reinvested and taxed when you take money out of the plan. The income earned in the 401(k) plan is tax deferred. Distributions from these plans are taxed as ordinary income when they are received.
It's possible for an investment to generate ordinary, short or long-term capital losses. The treatment of these losses as well as the type and amount of income and how they can be offset for tax planning purposes varies and is beyond the scope of this article.
Understanding what Basis Means
Let's move on to what happens when you sell an investment. Generally speaking, basis refers to the amount of your investment in an asset. To calculate the capital gain or loss when you sell, you must know how to determine both your initial basis and adjusted basis in the asset.
First, initial basis. Usually, your initial basis equals your cost — what you paid for the asset. For example, if you purchased stock for $10,000, your initial basis in the stock is $10,000. However, your initial basis can differ from the cost if you did not purchase the asset but rather received it as a gift or inheritance, or in a tax-free exchange.
Next, adjusted basis. Your initial basis in an asset can increase or decrease over time in certain circumstances. For example, if you buy a house for $100,000, your initial basis in the house will be $100,000. If you later install a $5,000 deck, your adjusted basis in the house may be $105,000.
Calculating your capital gain or loss
If you sell stocks, bonds, or other capital assets, you'll end up with a capital gain or loss. Special capital gains tax rates will apply. These rates are generally lower than ordinary income tax rates.
Basically, capital gain (or loss) equals the amount that you realize on the sale (i.e., the amount of cash and/or the value of any property you receive) less your adjusted basis in the asset. If you sell an asset for more than your adjusted basis, you'll have a capital gain. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $15,000, your capital gain will be $5,000. If you sell an asset for less than your adjusted basis in the asset, you'll have a capital loss. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $8,000, your capital loss will be $2,000.
Your holding period is also important in determining how your gain will be taxed.
- Holding period: Generally, the holding period refers to how long you owned an asset. A capital gain is classified as short term if the asset was held for a year or less and long term if the asset was held for more than one year. The tax rates applied to long-term capital gain income are generally lower than those applied to short-term capital gain income. Short-term capital gains are taxed at the same rate as your ordinary income. For this reason, in most situations, HCM attempts to capture long-term holding periods.
- Taxable income: Long-term capital gains and qualified dividends are generally taxed at special lower capital gains tax rates of 0%, 15%, and 20% depending on your taxable income. HCM tries to make the most of these lower rates. (However, some types of capital gains may be taxed as high as 25 or 28 percent.)
- Type of asset: The type of asset that you sell will dictate the capital gain rate that applies, and possibly the steps that you should take to calculate the capital gain (or loss). For instance, the sale of an antique is taxed at the maximum tax rate of 28 percent even if you held the antique for more than 12 months.
Using Capital Losses to Reduce Your Tax Liability
You can use capital losses from one investment to reduce the capital gains from other investments. Loss management is a valuable tool in managing your overall tax liability. This is the reason HCM focuses on loss harvesting when markets are volatile. You can also use a capital loss against up to $3,000 of ordinary income. Losses not used in one year can offset future capital gains.
New Medicare Contribution Tax on Unearned Income May Apply
High-income individuals may be subject to an additional 3.8 percent Medicare tax on unearned income (the tax, which first took effect in 2013, is also imposed on estates and trusts, although slightly different rules apply). The tax is equal to 3.8 percent of the lesser of:
- Your net investment income (generally, net income from interest, dividends, annuities, royalties and rents, and capital gains, as well as income from a business that is considered a passive activity), or
- The amount of your modified adjusted gross income that exceeds $200,000 ($250,000 if married filing a joint federal income tax return, $125,000 if married filing a separate return).
So, effectively, you're subject to the additional 3.8 percent tax only if your adjusted gross income exceeds the dollar thresholds listed above, and you have net investment income. It's worth noting that interest on tax-exempt bonds is not considered net investment income for purposes of the additional tax. Qualified retirement plan and IRA distributions are also not considered investment income.