As tax documents start to arrive, many people have questions regarding the taxability of capital gains, dividends, and interest.
Dividends are distributions of a company’s earnings to shareholders. Cash dividends are the most common form of dividends issued. Dividends can be issued as additional shares of stock or other property. Only some of the earnings will be distributed as dividends. The company keeps some profit to use for ongoing expenses and to fund future business activities.
You can receive your dividends in the form of a check or direct deposit, or you can choose to reinvest your dividends to purchase more shares. If you choose to reinvest your dividends, you are purchasing more shares of stock. That dividend amount would represent your cost basis of the newly purchased shares.
Capital gains/losses are the results of selling shares of stock or mutual funds. A capital gain means you sold something for a profit – the price you sold at is higher than your cost basis, the price you paid for the shares.
If you purchased 100 shares of stock XYZ for $10 per share, your cost basis is $1,000 (100 shares x $10 per share). During the following years, XYZ pays dividends of $100 and $150. You reinvest those dividends and purchase 50 more shares of stock. In year three, you sell your XYZ shares for $2,000. Your cost basis is now $1,250 ($1,000 original purchase + $250 of reinvested dividends). When the stock sells, you would have a capital gain of $750 ($2,000 sales price – $1,250 of adjusted cost basis).
If you were receiving your dividends in cash, your basis would remain at the original $1000, and you would still only own 100 shares.
Mutual funds often report capital gains – even if you personally did not sell any of your investment. A mutual fund is made up of many different stocks. If the mutual fund company sells one of the stocks within the fund, it can create a capital gain or loss, just like when you sell an individual stock. If the gains outweigh the losses at the end of the year for all stocks sold within the mutual fund, the investor receives a capital gain distribution.
A capital gain distribution is the portion of the proceeds from the fund’s sale of stock and other assets. Do not mistake this for the mutual fund’s overall profit. The fund itself may gain or lose money throughout the year. Suppose the mutual fund sells some stocks in its portfolio to raise cash or because of a concern about a particular investment. In that case, it can generate a profit that results in a capital gain distribution even if your overall investment lost value.
Just like with your dividends, when the mutual fund pays a capital gain distribution, you can elect to receive the distribution in cash or reinvest and purchase additional shares.
Many people believe that they do not have to pay any taxes because they did not receive a check. When you reinvest your capital gains distribution, you did receive the cash and then chose to use it to purchase more shares of the mutual fund. The reinvested capital gain distribution becomes your cost basis for the newly acquired shares.
Capital gain distributions result when the mutual fund sells shares of stocks within the fund. You generate capital gains or losses when you decide to sell your shares of the fund. Capital gain distributions are taxed each year. You delay paying the taxes on your investment until the mutual fund itself is sold. Some individuals will purchase exchange-traded funds (ETFs) rather than mutual funds to have better control over when taxes are required to be paid.
Dividends, capital gain distributions, and capital gains may be taxed at ordinary tax rates or lower capital gain rates. Currently, ordinary income tax rates are between 10% and 37%. Capital gains tax rates are 0%, 15%, or 20% and depend on your maximum ordinary income tax rate.
Dividends can be considered ordinary or qualified dividends. Ordinary dividends are taxed at ordinary income tax rates, while qualified dividends are taxed at the capital gain rates of 0%, 15%, or 20%. If you are in the 32% tax bracket, your ordinary dividends would be taxed at that rate, and your qualified dividends would be taxed at 20%. The investment company will notify you on your year-end tax document how much of your dividends are ordinary and how much are qualified.
Applying capital gain rates are determined by how long you have held the investment. If you purchase and sell the investment within one year, the sale is considered short-term and taxed at ordinary tax rates. If you hold the investment for more than one year, the sale is considered long-term and taxed at capital gain tax rates. Capital gain distributions are always considered long-term and taxed at the lower capital gain tax rates.
Dividends and capital gains are the earnings on stocks, mutual funds, and many alternative investments. These are investments where you own a portion of a company. Interest is earned when you have lent money through purchasing bonds. Interest earned can be taxable or tax-free. The terms tax-free and tax-exempt are often using interchangeably.
Tax-exempt interest is interest income that is not subject to federal income tax but may still be taxable at the state and local level. Municipal bonds are the most common type of investments that pay tax-exempt interest. Municipal bond interest is not taxed at the federal level.
Depending on the municipal bond purchased and which state you live in, you may or may not be subject to a state or local tax on the municipal bond. If you purchase a bond for the state you reside in, you may have interest free from state taxes. If you purchase a bond for another state, you may have to pay state taxes on that bond.
You will pay New York income taxes on California municipal bond interest if you are a NYS resident. If you purchased a New York municipal bond as a New York resident, you would not pay federal or New York income taxes on the interest earned. These interest taxation rules vary by state.
Treasury securities such as savings bonds issued by the U.S. government pay interest. This interest is tax-exempt at the state and local levels but taxable at the federal level. Most people choose to defer the taxes until they redeem the bond. If your savings bond matures in July and you do not cash it in, you are still required to report the interest when the bond matures. A bond that has reached maturity and stopped earning interest is automatically considered redeemed, and the interest amount is reportable to the IRS.
You do have the option of paying taxes on the interest each year when earned rather than waiting until maturity.
Taxable interest is earned on your savings account, bank CDs, insurance policies, burial funds, mortgage escrow account, and accounts held at financial institutions. Taxable interest is taxed at ordinary income tax rates. At the end of each tax year, you receive a 1099INT document showing the amount of interest earned if the amount earned is greater than $10 for the year.
No form is required to be sent to you if the interest earned is less than $10. You are still required to report this interest on your tax return. If your savings account earned $6.40 during the year, the bank or credit union would not send you a Form 1099INT. You are required to report the $6.40 of interest income on your tax return. You can typically find this amount on your year-end bank statement, or you can call the bank or credit union and ask for the amount if you do not receive a 1099INT.
Understanding how these items are taxed can help you decide when to sell a stock or mutual fund and its effect on your income taxes for the year of the sale. If you need help understanding or have questions about the taxation of your particular interest, stocks, mutual funds, and dividends, give Planning with Purpose a call. We would love to help!
