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Different types of investment returns are taxed distinctly. Knowing how investment returns are taxed can help you better manage your investments.

Short-Term Capital Gains

For an explanation of short term capital gains, imagine Bob:

Bob buys shares of Apple Inc. Bob’s timing is good, as the share price of Apple shoots up in the following 11 months. With a tidy gain in hand, Bob sells the stock – realizing his investment gain.

Bob is now faced with a tax on the short-term capital gain from the sale of this Apple stock. A short-term capital gain is distinct from a long-term capital gain. Short-term capital gains are defined by holding periods of one year or less. Short-term gains are taxed at the marginal rate. The marginal tax rate is the same tax rate Bob pays on his salary income – excluding payroll taxes and deductions.

Long-Term Capital Gains

Had Bob waited an additional month to sell his position, he would be looking at a long-term capital gain – which offers preferential tax treatment. The following chart displays the preferential long-term capital gains tax rate relative to an individual’s marginal tax rate.

You’ll notice that there is a substantial savings available to those who hold investments in excess of one year. Given a 10% investment return on a portfolio of $1,000,000 (or an investment return of $100,000), long-term holdings offer savings between $10,000 and $20,000 – depending on one’s tax bracket.

Interest Income

Like short-term capital gains, interest income is taxed at the marginal rate. This includes interest from a savings account, or interest from a United States Treasury bond.

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Certain municipal bonds do offer tax-exempt coupons. However, even with tax-free municipal bonds, certain tax-payers may still be subject to the Alternative Minimum Tax (AMT).

Ordinary Cash Dividends

Dividends from investments are taxed like interest – in that they are taxed at the marginal rate. This includes ordinary cash dividends issued from Real Estate Investment Trusts (REITs), and non-qualifying C-corporations. There are, however, exceptions.

Qualified Dividends

Cash dividends issued from a domestic corporation and held for a qualifying time period (“more than 60 days during the 121-day period that begins 60 days before the ex-dividend date”) also qualify for preferential tax treatment – identical to long-term capital gains.

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While it is always important to consider taxes, taxes should not dictate your investment strategy. Prioritize your asset allocation over tax mitigation. To quote one expert opinion:

Tax consequences are important, but not the most important.

~ Rick Ferri

References

Ferri, R. (2014, Jan 10). Taxes on Mutual Funds: Important Advice for Investors. Retrieved from The Wall Street Journal: http://online.wsj.com/news/articles/SB10001424052702303393804579311062915642246

Internal Revenue Service. (2013). Publication 17, Chapter 30 (2013), Your Federal Income Tax. Retrieved from Internal Revenue Service: http://www.irs.gov/publications/p17/ch30.html#en_US_2013_publink1000174222

Internal Revenue Service. (2013). Publication 17, Chapter 7 (2013), Your Federal Income Tax. Retrieved from Internal Revenue Service: http://www.irs.gov/publications/p17/ch07.html

Internal Revenue Service. (2013). Publication 17, Chapter 8 (2013), Your Federal Income Tax. Retrieved from Internal Revenue Service: http://www.irs.gov/publications/p17/ch08.html#en_US_2013_publink1000171584

Internal Revenue Service. (2014, Feb 27). Tax Topics – Topic 409 Capital Gains and Losses. Retrieved from Internal Revenue Service: http://www.irs.gov/taxtopics/tc409.html

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