Taxes on Investments: What Kansas Investors Should Know

The federal government first introduced taxation in the United States in 1861. The nature and reasoning for income tax have changed a lot since then and continue to be a headline-making topic. After all, who doesn’t love talking about taxes?!

As most know, the simplified computation involves applying a tax rate to a person’s taxable income generated in the calendar year. The applicable tax rate may increase as taxable income increases.

With that said, you face different rules and rates depending on the type of income that gets generated. For instance, calculating taxes on earned income from a job is very different from calculating taxes on income generated from investments. Today, we are going to focus on taxes on investments.

Capital Gains

Capital gains tax becomes due when you sell investments. This could include several types of assets used for investment purposes, including stocks, bonds, and real estate.

You can calculate the capital gain by taking the sales price minus the asset’s original cost (cost basis). When a profit is made, that’s a capital gain. It’s important to note—this income is generated or realized only when you sell the investment. You don’t owe tax while you still own the asset. Only when you sell your investment does the investment income get reported on your tax return.

Pretty straightforward so far, right?

Well, this is where it gets a bit more complex—we are talking about taxes, after all! First, you face different tax treatment depending on whether the capital gain is considered long term or short term.

To be considered a long-term capital gain, you need to have owned the asset for longer than one year. If it has been less than a year when you sell the investment, then it will be considered a short-term capital gain. This distinction is important because there are different tax rates depending on the holding period.

Short-term capital gains will be taxed at your ordinary income tax rate that year. Generally, this tax treatment is less preferable. If possible, it can be to your benefit to hold on to investments for more than a year to receive long-term capital gains tax treatment.

The tax rate paid on long-term capital gains is 0%, 15%, or 20%, depending on your taxable income. These rates are going to be lower than your ordinary income tax rate (which is used for calculating short-term capital gains).

If you are an investor with mutual funds, you also want to be aware of capital gains distributions. These occur when the mutual fund sells some of its holdings, and it passes the income on to the investors of that fund. This is an instance where capital gains are generated even if you didn’t sell the investment.

Capital Losses

Opposite to capital gains, if an investment is worth less than the original price when it’s sold, a capital loss will be realized.

Generally, any capital losses are used to offset realized capital gains. If you have more losses than gains at the end of the year, then the IRS allows you to claim a maximum loss of $3,000 on your tax return. Any losses in excess of $3,000 can be carried forward to future years’ tax returns.

If you are an experienced investor, you may be familiar with the concept of tax loss harvesting. This is the technique of intentionally selling investments at a loss to help offset capital gains in an effort to reduce taxes. This strategy is often implemented when there has been a significant market decline.

Dividend Income

Dividend income has some similar taxation concepts as capital gains. The tax rate paid on qualified dividends is 0%, 15%, or 20%, depending on your taxable income. And the determination of whether a dividend is qualified or nonqualified, in part, has to do with how long the investment has been held (sound familiar?).

Qualified dividends receive more favorable tax treatment, while nonqualified dividends are taxed at ordinary federal income tax rates. The holding-period requirement is a little more complicated than that of the capital gains requirement. And the rules are slightly different depending on whether the investment is common or preferred stock or a mutual fund.

Interest Income

I won’t spend too much time on interest income—for most people, it probably adds up to only a few dollars here and there, based on the current historically low interest rates!

You can earn interest income on a CD, savings, or money market account, as well as bonds you may own. A couple of notable exceptions include interest of U.S. Treasury bonds and savings bonds, which are taxable at the federal level but are typically not taxable on your state return.

Conversely, municipal bond interest is tax-free at the federal level and is also tax-free at the state level if you own a bond that is issued in the state you live. If you have taxable interest income, it is taxed at your ordinary income tax rate in the year it is paid.

Retirement Accounts

A quick note on retirement accounts: Taxation of retirement funds does not come into play until you take money out of a retirement account. You do not pay taxes on the money you earn in an account from year to year, as with other types of general investing accounts.

When you start distributing funds from a retirement account, the amount you withdraw may be taxable as ordinary income, depending on the type of retirement account.

There are few things in life more complex than taxes. OK, that might be a bit of a stretch—life is pretty complex. But taxes on investments are an essential consideration when it comes to investing. Our Topeka full-time fiduciary financial planning firm considers them a significant piece of a comprehensive financial plan and income strategy.

 

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Elizabeth Young, CFP®

As Partner and Senior Wealth Advisor, Elizabeth Young finds it gratifying whenever one of her clients reaches a long-held goal with her help and guidance. Those “aha” moments drive the work she does for our firm, including serving as the primary financial planning contact for clients and overseeing general client service.