An Introduction To Taxation On Investments

Many of you have done everything right.  You have worked hard, saved your money, paid taxes on your income annually and have set aside extra funds to take care of some special need in the future.  Any earnings on these extra funds, just like the income you receive for your labor, are subject to taxation.  Unlike income tax on labor, taxes on your investment account are treated similar to tax treatment of a business.  Most businesses are acutely aware of the need to minimize taxation to maximize profit and have a staff full of experts to guide them to this end.  You on other hand maybe going it alone, or with a little guidance from your tax preparer.  In either case,thinking of your investment account as a business with a single employee, the Federal Government, whose pay is solely dependent upon the profitability of your investment activities.  Your employee will receive a share of your profits, but he will also share in any loss you may take.  The amount you will pay can change depending upon how and when you earn a profit.  Knowing this allows you to manage your affairs in such a way as to minimize the amount of tax you are required to pay.

The overall tax rate you pay is the most important consideration you have.  Most of us only consider the marginal tax rate, or the tax rate applied to the last dollar earned, which is normally attributed to investment income, and the highest stated rate for federal income taxes, currently 35%.  The overall tax rate paid is actually the result of the type of income earned and the deductions applied to that income.  This is known as the effective rate and may actually be higher than the marginal rate.  

This is what you need to know:

1.  You normally will pay tax on income you receive for interest and dividends at your marginal    tax rate but special rules apply to dividends.
2.  Profits earned from an appreciated security are currently considered a capital gain and subject to the same rate applied on your ordinary income but is currently capped at 15% for a security held more than twelve months.
3. If a security is sold at a loss, then a deduction against ordinary income in the amount of the loss, currently capped at $3,000 per year, after netting the loss against any capital gains.
4. Some appreciation in a security owned may be deferred or the obligation for the taxes due when sold may be transferred through a gift or contribution, but never eliminated.
5. Rules that do not apply directly to your investment account may still impact your effective tax rate due to the complex adjustments to allowable deductions, exemptions, and the Alternative Minimum Tax.
6. Special rules apply to other investments, such as real estate, collectables and options.
7. Tax laws change.  Keeping up with the new rules that impact your portfolio is mandatory.  Consider hiring a professional tax advisor.

Knowing the rules is a big step towards maximizing after tax profits.  The real success comes from how we manage our investments to minimize our effective tax rate while maximizing our returns to meet our goals.