Varying Rates: Taxes on Investments & Capital Gains

If you have investment assets, you need to understand how the capital gains tax works. Not all investments trigger the capital gains tax, which is frequently lower than an individual's income tax rate. Depending on the types of investment vehicles you own and how they are structured, as well as factors like the economy and whether you bought or sold investments during the year, your tax bill could increase or decrease after factoring in investment income.

Short-Term and Long-Term Capital Gains

Capital gains and capital losses occur when qualifying investments are sold for a profit or a loss. The capital gains tax rate tops out at 20 percent, which represents an increase over the prior rate, 15 percent. This tax is most commonly used for stocks, bonds, and mutual funds. However, not all income from these sources triggers a capital gains tax (CGT) – some types of income, like interest and dividends, are taxed in the same way as ordinary income. Short-term CGTs apply to investments owned for less than twelve months; investments held longer than twelve months trigger long-term CGTs. Short-term CGTs are equal to your income tax rate. If you lose money on a long-term investment sale, you can deduct money from the CGT you owe on other investments that year, up to a certain amount.

Capital losses can be carried over from one year to the next, which means if you take a large loss one year, you may be able to reduce your tax liability in the future, assuming you later receive a profit on an eligible investment. You can also offset up to $3,000 of ordinary income per year with a capital gains loss.

Mutual funds can trigger CGTs, too. Anytime your mutual fund's manager makes a trade that results in a profit or a loss, CGTs come into play. Mutual funds are obligated to issue 1099 forms listing profits and losses to investors each January. If you sell your holdings in a mutual fund, that will also be a taxable event. The amount of tax you will pay depends on how long you held shares in the mutual fund. Because of the complexity of CGTs, you may wish to use tax filing software to help you organize your 1099s and sales records.

Taxation of Dividends and Interest

Dividends are paid by stocks and sometimes mutual funds. Whether or not a dividend is paid depends on the performance of the investment, the fund's rules, and other factors. Dividends are taxed as ordinary income, not capital gains. By definition, dividends cannot be losses. If you own bonds, you may receive interest. Interest from bonds is taxed in the same manner as income. Of course, sales of bonds can still trigger CGTs if held for more than a year.

Muni Bonds, the AMT, and Other Considerations

Some bond interest does not generate an income tax liability, such as interest paid by municipal bonds. It may seem like the answer to low tax liability is a portfolio full of municipal bonds and long-term investments, but that is not necessarily true. In these circumstances, the alternative minimum tax (AMT) may be triggered, resulting in an even higher tax rate. For this reason, any investment portfolio should be carefully planned and maintained. Financial planning software can make it easier.

Understanding the different tax rates that your investments may trigger is an important step for your annual tax preparation.

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