Taxes and Your Investment Returns

Taxation is the price you pay for being successful in your financial investments. Dividends and interest earned are taxable as ordinary income. Trading in stocks, bonds and mutual funds has many advantages, but the turnover of securities within your portfolio often causes the realization of capital gains, the profits from a security’s selling price that are above the price at which the security was purchased, which are also taxable. It’s very important that you develop an investment strategy that is as tax-efficient as possible.

Publicly held corporations will tell you whether or not their distributions to you are taxable. Taxable dividends paid to you are reported to the Internal Revenue Service (IRS) on Form 1099-DIV, a copy of which must be sent be sent to you. Taxable interest that’s paid to you is reported on Form 1099-INT.

Below you can see the impact of federal taxes on various types of investment distributions and capital gains:

• Cash dividends. Cash dividends you receive that are paid out of current or accumulated earnings of a corporation are taxed as ordinary income.
• Stock dividends and stock splits. If you own common stock and receive additional shares of the same company as a dividend, the dividend is not generally taxed. A stock dividend is taxed if you choose to receive cash instead of stock or if the stock you receive is that of another company. Preferred shareholders are generally taxed on stock dividends. Stock splits are similar to the receipt of stock dividends, but they are not dividends. If you receive additional shares of stock as part of a stock split, the new shares are not taxable due to the fact that even though you own more shares, your ownership percentage in the company hasn’t changed.
• Real Estate Investment Trust (REIT) dividends. Ordinary dividends from a REIT are fully taxable. Dividends designated by the REIT as capital gain distributions are reported as long-term capital gains regardless of the length of time you’ve owned your trust shares.
• Money-market fund distributions. Distributions paid by money-market funds are reportable as dividends.
• Interest on corporate bonds. Interest is taxable when you receive it or when it’s made available to you.
• Interest on U.S. Treasury obligations. Interest on securities issued by the federal government is fully taxable on your federal income tax return in the year that it’s received. It is not subject to state or local taxes, however. On a Treasury bill held to maturity or disposed of prior to that time, you report as interest the difference between the discounted price you paid and the amount you receive upon redemption or sale.
• Interest on state and local government obligations. Generally, you pay no federal tax on the interest on bonds or notes of states, cities, counties, the District of Columbia, or possessions of the United States.
• Capital gains and losses. Net capital gains (capital gains less capital losses) are added to your other income and are subject to capital gains tax rates. Capital losses are deductible from capital gains and are deductible from as much as $3,000 of your ordinary income, with a carryover to subsequent years of losses in excess of $3,000.