Tax Implications of Investments

The main goal for our investments is, to appreciate over time. It comes as no surprise, that taxes are owed on this appreciation. And yet, the tax consequences of investments are often ignored. In this post, we will briefly explain the basics.

Before we begin, let’s point out that this post does not attempt to provide tax advice. Please consult with a tax professional, for a more in-depth analysis of your specific situation. Instead, we want to provide a high-level overview and raise awareness of the most important aspects.

Taxes on stocks

In most investment portfolios, stocks are the main driver for growth. This growth is achieved through 2 mechanisms: capital gains, and dividends.

Capital gains

Capital gains occur, when we buy a stock at price A, and sell it later at price B. The capital gain is the difference between the two, or B minus A, and tax is owed on these capital gains.

The moment we close a stock position, we create a taxable event. The rate at which the capital gains are taxed depends on the time we held the stock, and we distinguish short-term capital gains from long-term capital gains:

  • Short-term capital gains: If we held our stock position for a year or less, this is considered short-term. We owe taxes at our normal income tax rate.
  • Long-term capital gains: If we held our stock position for more than a year, this is considered long-term. We owe taxes at a reduced tax rate, which in 2019 amounts to 15% for most investors.

Now, there will also be situations where we realize losses. In general, gains and losses are netted against each other. But there are important exceptions to consider:

  • If the losses exceed the gains, we may deduct the losses from our income. However, there is a limit to the capital losses we may deduct per year. In 2019, this limit is at $3,000 per household. The remainder of the losses will be carried forward to later years.
  • If we re-purchase the same security we just sold within 30 days, a so-called wash-sale occurs. Under these circumstances, we cannot deduct our losses. Instead, the loss is added to the cost basis on the re-purchase.

Dividends

When a company distributes a portion of its earnings and profits to its shareholders, it is doing so by paying a dividend. Dividends are taxed the year they become available. We distinguish the following main groups:

  • Ordinary dividends: these are taxed at the normal income tax rate.
  • Qualified dividends: most dividends of US companies should fall in this category, but it is worth double-checking. Qualified dividends are taxed at the reduced rate for capital gains.

Total returns

But how much of our total returns stems from capital gains, and how much from dividends? The answer of course depends on the stock we are investing in. As a general guidance, here is a graphic showing S&P 500 since January 2008:

S&P 500 price and accumulated dividends from 2008 to 2019

As we can see, the majority of the growth stemps from fluctuation in price, resulting in capital gains. A much smaller portion stems from the accumulated dividends.

As we have explained above, a taxable event only occurs after we realize capital gains. With capital gains being stocks’ major source of growth, there is an important take-away: We can enjoy the majority of our stock’s appreciation without being taxed, as long as we keep holding the position.

For more details, the IRS provides very valuable information in the form of short ‘tax topics’:

Taxes on bonds

In most investment portfolios, bonds are the main source of income. This income is usually paid in the form of interest.

Principal

When we buy a bond, we lend a principal amount of money to the issuer of the bond. When the bond matures, this principal is paid back. This exchange of this principal is tax free.

Capital gains

Bonds are traded on the capital markets in a fashion quite similar to stocks. This is even more true, when they are bundled together to exchange-traded products like ETFs. The bond prices are determined by supply and demand, and therefore capital gains may occur, as discussed in the section above.

Interest

The issuer of the bond typically pays an interest on the principal we provided. Interest is usually taxed as ordinary income in the year it becomes available to you.

However, some interest you receive may be tax excempt. The most important source for tax-excempt interest are municipal bonds, which are not taxable on the federal level.

Total returns

Just like we did with stocks before, let us have a look at historical data, to get a better idea of the composition of bond’s total returns. The following graphic shows the aggregate US bond market between 2008 and 2019:

Aggregate bond prices and accumulated interest payments from 2008 to 2019

We can see, that over the observed period bond prices remained mostly flat. This indicates that capital gains play only a minor role in the tax consideration of bonds. Instead, the majority of the returns stem from interest payments.

This leads us to an important take-away: unlike with stocks, we should not shy away from closing out a bond position, if there is a better opportunity elsewhere. Typically there will be only little penalty in the form of capital gains, but an immediate benefit through higher interest payments.

For further details, see the IRS tax topics:

We very much hope that this post provided some valuable insight into the taxation of your investments. At Bertram Solutions we aim to minimize taxes, while still offering the benefits of active management.