Congress has developed a convoluted system that taxes various financial transactions differently. Recent press has focused on how the rich pay less tax. That is simply because they generate their income from the sources that IRS taxes the least (you would do the same if you were rich). While this is difficult for you to do during your working years (income from working is taxed at the most onerous rates, called "ordinary income rates"), paying less tax becomes easier in retirement even if your income is high.
Beyond fees and financial transaction costs, most all investments are subject to taxation - and this symbolizes more cost for you that may lower your return. Let's see what is taxed and when. By comprehending how different investments are subject to taxes, you are able to do investment planning and thereby keep money that others pay to the Federal and state government.
Federal government taxes you on both income and capital gains. Shares, bonds and mutual funds symbolize the vast majority of investments retirees have.
Mutual fund taxation:
Once you buy and hold mutual fund shares, you will owe income tax on any ordinary dividends you receive on them throughout the year - whether you receive the dividends or automatically reinvest them. Sound investment planning tells you to never purchase mutual funds near the end of the year or you will be taxed on all of the fund's income accumulation for the entire year. of course, the above does not apply to investments in tax-free mutual funds whereby the income generated is free from tax (but not any capital gains).
If you sell your mutual funds for more than you bought them, you will have a capital gain - otherwise a capital loss.
But you might also have to pay taxes every year on the fund's internal capital gains that occur from the fund selling its underlying securities at a net profit. The fund passes these gains on to you as 'distributed' capital profits in proportion to the shares you own in the fund. Investment planning specialists suggest purchasing index funds simply because all the gains will be long-term and taxed at lower rates (15% in 2012) as opposed to short-term gains generated by many growth funds (taxed at up to 35%).
Individual Stock or bond taxation:
When you buy and hold an individual stock or bond, you have to pay income tax every year on dividends or interest you get. Tax rates will range from 15% to 35%, depending on the nature and timing of the income. So use some investment planning to make certain that your stocks produce 'qualified' dividends. But you will not have to pay any capital gains tax till you sell your stock or bond. And of course a profit means you sold your stock or bond for more than you bought it for - otherwise it's a capital loss. Again, some investment planning might help many people reduce the capital gains rate to 0% (see how to pay 0% tax on capital gains and dividends). Before you invest or sell, make sure you understand the tax impact or ask your advisor or accountant.
Tax Free Funds:
If you invest 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) tax because they arise from interest from the underlying tax-free investments (interest on money lent to states and cities).
But you may nonetheless owe capital gains tax on the fund's gains for any selling of the underlying bonds at a profit. These are usually insignificant.
And, of course, you will owe personal capital gain tax once you sell your tax-exempt fund shares for more than you purchased them. Investment planning specialists often suggest purchasing individual municipal bonds and hold to maturity and avoid unnecessary gains tax.
Capital Gain Tax Rates;
Remember, capital gain taxation occurs at special rates. These are lower than income tax rates (ordinary income rates). This is how rich people pay less tax. Warren Buffet, for example would be wise to take no salary from his business as it would be taxed highly. Rather, he simply takes a share of the capital gains on stocks held more than a year and pays no more than 15%. he does nothing fancy other than what Congress allows.
The capital gain rates that apply to you depend on what income tax rate you are in - see table below. Using benefits at the appropriate time is the type of investment planning done by innovative investors as your tax bracket affects your capital gains liability.
|Tax Rates on Capital Gains of Securities|
|Capital asset||Holding period||Tax rate|
|Short-term capital gain||1 year or less||Ordinary income tax rate (up to 35%)|
|Long-term capital gain||More than 1 year||0% for qualified dividends if you're in the 10% or 15% income tax bracket (ends 12/31/2012)
15% for qualified dividends if you're in the 25% or higher income tax bracket