Tax Implications of Investments

“In this world nothing can be said to be certain, except death and taxes.”– Ben Franklin

• IRS got Capone; tax is not to be taken lightly. 
• Post-tax return is the real return.
• Investment income is tax-deferred in individual retirement accounts (IRAs).
• Short-term capital gain tax rate is your marginal tax rate; long-term capital gain tax bracket is 0%, 15% or 20%.
• Stock value appreciation is taxed as short-term capital gain if said stock is held for less than a year; long term rate for over a year.
• Dividend income from most U.S. stocks are taxed as either ordinary income (short-term) or qualified dividend (long term).
• Interest/dividend payments from fixed income investments, such as high-yield savings account, certificate of deposit (CDs), Real estate investment trust (REIT), peer to peer (P2P) lending, corporate bonds are taxed as ordinary income.
• Interest/dividend payments and value appreciations from U.S Treasure bonds and municipal bonds are tax-exempt. 
• Commodity market gains are taxed differently than equity and bonds. Futures contract profit is subject to 60% long-term capital gain tax and 40% short-term capital gain.
• $3,000 is the maximum amount to deduct against income for personal investment loss annually; however, excessive loss can be carried into following years.
• If one is qualified by IRS as a trader instead of an investor, the tax regulation would be much more lenient. However, it is quite difficult to be qualified according to IRS rules.
• Wash sale rule – If an asset is sold at a loss and repurchased within 30 days, the loss is not tax deductible.
• Tax loss harvesting – selling an asset at a loss by the end of the fiscal year to offset the tax on realized gain in the same year.

When a profit is made by selling a stock that was held for less than a year, the profit is subject to short term capital gain tax. The rate is equivalent to each individual’s marginal income tax rate. Simply, short term capital gain is taxed as your ordinary income. For example, if Jerry’s expected taxable income of FY2019 is $100,000 (after deductions and write-offs, filed as a single unmarried, no dependent individual), his marginal tax rate, or tax bracket is 24%. During 2019, Jerry bought and sold 100 shares of APPL and made a profit of $5,000. That $5,000 would be taxed 24%, or $1,200, leaving him $3,800 net return from this trade.

On the other hand, if the 100 shares of APPL were held for more than one year before they were sold in 2019, netting Jerry the same amount of $5,000 profit. This $5,000 would be taxed as long-term capital gain. With an annual income of $100,000, Jerry’s long-term capital gain rate is 15%, which leaves him $4,250 in net return from this sale.

The aforementioned examples are for profits from appreciation in market value in an underlying stock only. For most large cap stocks, they also pay out monthly or quarterly dividends. Common dividends are the distribution of profit that a corporation pays to its shareholders.

Let’s take a look at APPL again as an example. With a historical yield of 1.37%, APPL pays out its dividend on a quarterly basis. If Jerry owns 100 share of APPL on its last ex-dividend date, 11/07/19, he would receive a dividend of $0.77 per share, a total of $77 cash into his trading account.

Some amateur investors neglect the importance of dividend yield due to its “insignificant” amount compared to stock’s market value change, after all, a whopping five grand profit dwarfs a measly $70 payment every three months. This is a horrific mistake, which would be further discussed later. As of now, we will focus only on the tax aspect of stock dividends. 

Now, how to tax the $77 gets quite complicated. According to IRS, all dividend income from investments is taxed as ordinary income (thus subject to short-term capital gain tax), except for qualified dividends, which are taxed as long-term capital gain.

As mentioned above, long-term capital gain tax enjoys a much lower rate but much more strictly criteria. In the case of stock dividends, the shares must have been owned by you for more than 60 days of the “holding period” — which is defined as the 121-day period that begins 60 days before the ex-dividend date or the day on which the stock trades without the dividend priced in. 

With the example of Jerry’s trade on APPL,  the stock’s ex-dividend date is 11/07/2019. The 100 shares must be held for more than 60 days in the period between 09/08/2019 and 01/06/2020 for this $77 to be taxed as qualified dividend, with a long term capital gain rate of 15%.

It is time to apply all the information above to solve real-life tax problems.

Jerry bought 100 shares of APPL on 4/30/2018 at $165 per share. After a volatile second half of 2018, APPL has rallied into its all time high of $270 per share as of 12/06/2019. Jerry decides it’s time to reap the handsome gain and reward himself a winter getaway vacation, surfing in Hawaii. He sells the shares and makes a pre-tax profit of $10,500 from the market value appreciation. Since the shares were held for more than one year, the profit is subject to long capital gain tax of 15%. Jerry would have to set aside $1,575 for tax on this trade.

During the time Jerry held APPL, it has paid out dividends a total of $523. According to IRS dividend rule, APPL as an U.S. corporation and the long term Jerry had held APPL, the $523 is considered as qualified dividend, subject to long term capital gain of 15%. In summery, Jerry makes net gain of 0.85x($10500+$523) = $9,369.55; and he has to set aside 0.15x($10500+$523)=$1,652.45 for his federal income tax on this trade.

Vikram, Jerry’s successful friend who works in tech, makes a nice $250,000/year taxable income as an eligible bachelor (dependent-less, of course). Consequently, his short-term capital gain rate is 35%, while his long-term capital gain rate is 15%, same as Jerry. Vikram bought in 100 APPL at $165/share on 1/30/2019 and sold them on 12/06/2019 for $270 per share, at APPL’s all time high. He made the same amount of profit as Jerry from the stock’s value change, which is $10,500. However, the dividend Vikram received during this period is $304. Since he held this stocks for less than a year before selling, while the three dividend payments were all qualified as long-term capital gain, Vikram has to pay 35%($10500)+15%(304)=$3,720.6 tax for this gain; leaving him a net profit of $7,083.4.

Now, McLovin, who is more of a short-term trader than an investor. Mclovin makes about $50,000 taxable income from his day job, which put his marginal tax rate at 22% and long term capital gain rate at 15%. He bought 100 shares of BAC on 08/30/2019 for $27.5 per share and sold them on 10/29/2019 for $32 per share, raking in a profit of $450. During this time BAC paid out a dividend of $0.18 per share on 09/05/2019, giving McLovin $18 cash. The total tally of this gain is $468, which is all subject to short-term capital gain tax of 22% for Sir McLovin, leaving him a net gain of 0.78x($450+$18) = $336.96; while he needs to pay 0.22x($450+$18)=$102.96 for taxes.