Ask the Analyst: What Investors Need to Know About Taxes

When it comes to investing, the taxman cometh for all of us (sooner or later). But how much you’ll end up paying and when depends on the type of distributions made and the timing of gains realized.

For my new Ask the Analyst series, I’m answering your questions about investing, personal finance, and retirement planning. Today’s question is about taxes:

“Taxes reduce returns. What do investors need to know? Is ordinary income taxed differently from qualified dividends/capital gains?”

Three Types of Investing Income

Ordinary income comes from interest paid on savings accounts, money market funds, CDs, and bonds (or funds that invest in bonds). If you sell a stock, bond, or fund that you’ve owned for 12 months or less, the resulting short-term capital gain is taxed at ordinary income rates, meaning that it’s taxed at your marginal tax rate.

Income from US Treasury securities and other government obligations (including Treasury Inflation-Protected Securities) is fully taxable at the federal level but exempt from state and local income taxes. That can help ease the tax burden, especially for investors in high-tax states such as California, New York, New Jersey, and Hawaii.

Qualified dividends are dividends paid by a US corporation or certain foreign companies. To be considered qualified, the underlying security must meet a minimum holding requirement; you must hold the stock for more than 60 days out of the 121-day period that begins 60 days before the ex-dividend date, which is the day when dividends officially “exit” from the stock price. Qualified dividends are taxed at more favorable capital gains rates. Dividends that don’t meet the qualified dividend requirements are considered ordinary dividends and taxed as ordinary income.

Capital gains reflect the profit you make after selling an investment. Long-term capital gains apply to investments that were held for more than one year before the sale and are generally taxed at 0%, 15%, or 20%, depending on your taxable income. Different rates apply to some investments, such as collectibles (28%) and some types of real estate (25%).

If you own a mutual fund, you might end up with taxable capital gains even if you don’t make a sale. Funds are structured as regulated investment companies under the Internal Revenue Code and are required to distribute “substantially all” of their realized capital gains to shareholders. Funds themselves don’t pay any taxes; instead, the tax burden gets passed on to shareholders.

Funds end up realizing if they sell securities for more than the purchase price, either as part of their regular strategy or if they’re forced to raise cash to meet redemptions from shareholders. In general, funds with higher portfolio turnover tend to distribute more capital gains compared with funds that don’t trade as actively.

On average, tax costs for the typical mutual fund in the US equity category group took 1.67 percentage points out of annualized returns over the past five years (based on tax rates for investors in the highest tax bracket).

Exchange-traded funds have been significantly more tax-efficient because of a structural advantage—the ability to make “in-kind” redemptions. When investors sell ETF shares, they typically sell the shares to other investors on an exchange. And when large institutions sell shares, the ETF can transfer actual securities from the fund’s portfolio instead of selling them, thereby avoiding realized capital gains at the fund level.

Other Considerations

Funds that invest in international stocks come with some other tax complications, as foreign governments typically withhold taxes on dividends before you receive them. However, US-based investors can claim a foreign tax credit to neutralize the impact of this withholding.

Across all types of investments, investors can minimize tax drag by holding less tax-efficient funds in a tax-advantaged account, such as a 401(k) or an IRA. In particular, real estate investment trusts tend to be less tax-efficient because their dividends aren’t considered qualified and are therefore taxed at higher ordinary income rates (although up to 20% of the dividend amount may be deductible).

Target-date funds typically don’t make a great fit for taxable accounts, either. Investors in Vanguard’s target-date fund series learned that the hard way when several funds in the lineup made large capital gains distributions after numerous shareholders switched to a newly introduced share class with lower expenses.

Have a Question for Me?

In this new Ask the Analyst series, I’m answering questions from readers about investing, personal finance, and retirement planning. If you have a question you’d like to ask, please fill out a quick survey.