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Taxation of Investments

Taxation of Investments

It’s nice to own stocks, bonds, and other investments. Nice, that is, until it’s time to fill out your federal income tax return. At that point, you may be left scratching your head. Just how do you report your investments and how are they taxed?

Is it ordinary income or a capital gain?

To determine how an investment vehicle is taxed in a given year, first ask yourself what went on with the investment that year. Did it generate interest income? If so, the income is probably considered ordinary. Did you sell the investment? If so, a capital gain or loss is probably involved. (Certain investments can generate both ordinary income and capital gain income, but we won’t get into that here.)

If you receive dividend income, it may be taxed either at ordinary income tax rates or at the rates that apply to long-term capital gain income. Dividends paid to an individual shareholder from a domestic corporation or qualified foreign corporation are generally taxed at the same rates that apply to long-term capital gains. In 2013, these rates are 0 percent for an individual in the 10 or 15 percent marginal tax rate bracket,15 percent for an individual in the 25 percent, 28 percent, 33 percent, or 35 percent tax rate bracket, and 20 percent for those in the top (39.6 percent) tax bracket. But special rules and exclusions apply, and some dividends (such as those from money market mutual funds) continue to be treated as ordinary income.

The distinction between ordinary income and capital gain income is important because different tax rates may apply and different reporting procedures may be involved. Here are some of the things you need to know.

Categorizing your ordinary income

Investments often produce ordinary income. Examples of ordinary income include interest and rent. Many investments–including savings accounts, certificates of deposit, money market accounts, annuities, bonds, and some preferred stock–can generate ordinary income. Ordinary income is taxed at ordinary (as opposed to capital gains) tax rates.

But not all ordinary income is taxable–and even if it is taxable, it may not be taxed immediately. If you receive ordinary income, the income can be categorized as taxable, tax exempt, or tax deferred.

  • Taxable income: This is income that’s not tax exempt or tax deferred. If you receive ordinary taxable income from your investments, you’ll report it on your federal income tax return. In some cases, you may have to detail your investments and income on Schedule B.
  • Tax-exempt income: This is income that’s free from federal and/or state income tax, depending on the type of investment vehicle and the state of issue. Municipal bonds and U.S. securities are typical examples of investments that can generate tax-exempt income.
  • Tax-deferred income: This is income whose taxation is postponed until some point in the future. For example, with a 401(k) retirement plan, earnings are reinvested and taxed only when you take money out of the plan. The income earned in the 401(k) plan is tax deferred.

A quick word about ordinary losses: It’s possible for an investment to generate an ordinary loss, rather than ordinary income. In general, ordinary losses reduce ordinary income.

Understanding what basis means

Let’s move on to what happens when you sell an investment vehicle. Before getting into capital gains and losses, though, you need to understand an important term–basis. Generally speaking, basis refers to the amount of your investment in an asset. To calculate the capital gain or loss when you sell or exchange an asset, you must know how to determine both your initial basis and adjusted basis in the asset.

First, initial basis. Usually, your initial basis equals your cost–what you paid for the asset. For example, if you purchased one share of stock for $10,000, your initial basis in the stock is $10,000. However, your initial basis can differ from the cost if you did not purchase an asset but rather received it as a gift or inheritance, or in a tax-free exchange.

Next, adjusted basis. Your initial basis in an asset can increase or decrease over time in certain circumstances. For example, if you buy a house for $100,000, your initial basis in the house will be $100,000. If you later improve your home by installing a $5,000 deck, your adjusted basis in the house may be $105,000. You should be aware of which items increase the basis of your asset, and which items decrease the basis of your asset. See IRS Publication 551 for details.

Calculating your capital gain or loss

If you sell stocks, bonds, or other capital assets, you’ll end up with a capital gain or loss. Special capital gains tax rates may apply. These rates may be lower than ordinary income tax rates.

Basically, capital gain (or loss) equals the amount that you realize on the sale of your asset (i.e., the amount of cash and/or the value of any property you receive) less your adjusted basis in the asset. If you sell an asset for more than your adjusted basis in the asset, you’ll have a capital gain. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $15,000, your capital gain will be $5,000. If you sell an asset for less than your adjusted basis in the asset, you’ll have a capital loss. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $8,000, your capital loss will be $2,000.

Schedule D of your income tax return is where you’ll calculate your short-term and long-term capital gains and losses, and figure the tax due, if any. You’ll need to know not only your adjusted basis and the amount realized from each sale, but also your holding period, your marginal income tax bracket, and the type of asset(s) involved. See IRS Publication 544 for details.

  • Holding period: Generally, the holding period refers to how long you owned an asset. A capital gain is classified as short term if the asset was held for a year or less, and long term if the asset was held for more than one year. The tax rates applied to long-term capital gain income are generally lower than those applied to short-term capital gain income. Short-term capital gains are taxed at the same rate as your ordinary income.
  • Marginal income tax bracket: Marginal income tax brackets are expressed by their marginal tax rate (e.g., 15 percent, 25 percent). Your marginal tax bracket depends on your filing status and the level of your taxable income. When you sell an asset, the maximum tax rate that applies to the gain will depend on your marginal income tax bracket. In 2013, a 0 percent long-term capital gains tax rate generally applies to individuals in the 10 or 15 percent tax bracket, a 15 percent maximum rate applies to those in the 25 percent, 28 percent, 33 percent, or 35 percent tax bracket, and a 20 percent maximum rate applies to those in the top (39.6 percent) tax bracket.
  • Type of asset: The type of asset that you sell will dictate the capital gain rate that applies, and possibly the steps that you should take to calculate the capital gain (or loss). For instance, the sale of an antique is taxed at the maximum tax rate of 28 percent even if you held the antique for more than 12 months.

Using capital losses to reduce your tax liability

You can use capital losses from one investment to reduce the capital gains from other investments. You can also use a capital loss against up to $3,000 of ordinary income this year ($1,500 for married persons filing separately). Losses not used this year can offset future capital gains. Schedule D of your federal income tax return can lead you through this process.

New Medicare contribution tax on unearned income may apply

High-income individuals may be subject to a new 3.8 percent Medicare contribution tax on unearned income in 2013 (the new tax is also imposed on estates and trusts, although slightly different rules apply). The tax is equal to 3.8 percent of the lesser of:

  • Your net investment income (generally, net income from interest, dividends, annuities, royalties and rents, and capital gains, as well as income from a business that is considered a passive activity), or
  • The amount of your modified adjusted gross income that exceeds $200,000 ($250,000 if married filing a joint federal income tax return, $125,000 if married filing a separate return)

So, effectively, you’re subject to the additional 3.8 percent tax only if your adjusted gross income exceeds the dollar thresholds listed above. It’s worth noting that interest on tax-exempt bonds is not considered net investment income for purposes of the additional tax. Qualified retirement plan and IRA distributions are also not considered investment income.

Getting help when things get too complicated

Having a financial advisor to help guide your decisions is critical and our team at Sterling Group has you covered. If you would like to minimize your tax liability, contact us today at Sterling Group United.

 

Tax Planning for Income

The goal of income tax planning is to minimize your federal income tax liability. You can achieve this in different ways. Typically, though, you’d look at ways to reduce your taxable income, perhaps by deferring your income or shifting income to family members. You should also consider deduction planning, investment tax planning, and year-end planning strategies to lower your overall income tax burden.

Postpone your income to minimize your current income tax liability

By deferring (postponing) income to a later year, you may be able to minimize your current income tax liability and invest the money that you’d otherwise use to pay income taxes. And when you eventually report the income, you may be in a lower income tax bracket.

Certain retirement plans can help you to postpone the payment of taxes on your earned income. With a traditional 401(k) plan, for example, you contribute part of your salary into the plan, paying income tax only when you later withdraw money from the plan (withdrawals before age 59½ may be subject to a 10 percent penalty). This allows you to postpone the taxation of part of your salary and take advantage of the tax-deferred growth of any investment earnings.

There are many other ways to postpone your taxable income. For instance, you can contribute to a traditional IRA, buy permanent life insurance (the cash value part grows tax deferred), or invest in certain savings bonds. You may want to speak with a tax professional about your tax planning options.

Shift income to your family members to lower the overall family tax burden

You may also be able to minimize your federal income taxes by shifting income to family members who are in a lower tax bracket. For example, if you own stock that produces dividend income, one option might be to gift the stock to your children. After you’ve made the gift, the dividends will represent income to them rather than to you. This may lower your family’s overall tax burden. Keep in mind that you can make a tax-free gift of up to $14,000 (the amount was $13,000 for 2012) per year per recipient without incurring federal gift tax.

However, look out for the kiddie tax rules. Under these rules, for children (1) under age 18, or (2) under age 19 (or full-time students under age 24) who don’t earn more than one-half of their financial support, any unearned income over $2,000 in 2013 ($1,900 for 2012) is taxed at the parent’s marginal tax rate. Also, be sure to check the laws of your state before giving securities to minors.

Other ways of shifting income include hiring a family member for the family business and creating a family limited partnership. Investigate all of your options carefully before making a decision.

Deduction planning involves proper timing and control over your income

Lowering your federal income tax liability through deductions is the goal of deduction planning. You should take all deductions to which you are entitled, and time them in the most efficient manner.

As a starting point, you’ll have to decide whether to itemize your deductions or take the standard deduction. Generally, you’ll choose whichever method lowers your taxes the most. If you itemize, be aware that some deductions (for example, medical and miscellaneous expenses) are allowed only to the extent the deduction exceeds some percentage of your adjusted gross income (AGI). Also, for 2013 an overall limitation on itemized deductions may apply to individuals with high AGIs (note: no such limitation applied for the 2012 tax year). In cases where your deductions are affected by your AGI, you might look at ways to potentially increase your allowable deductions by reducing your AGI. To lower your AGI for the year, you can defer part of your income to next year, buy investments that generate tax-exempt income, and contribute as much as you can to qualified retirement plans.

Because you can sometimes control whether a deductible expense falls into the current tax year or the next, you may have some control over the timing of your deduction. If you’re in a higher federal income tax bracket this year than you expect to be in next year, you’ll want to consider accelerating deductions into the current year. You can accelerate deductions by paying deductible expenses and making charitable contributions this year instead of waiting until next.

Investment tax planning uses timing strategies and focuses on your after-tax return

Investment tax planning seeks to minimize your overall income tax burden through tax-conscious investment choices. Several potential strategies may be considered. These include the possible use of tax-exempt securities and intentionally timing the sale of capital assets for maximum tax benefit.

Although income is generally taxable, certain investments generate income that’s exempt from tax at the federal or state level. For example, if you meet specific requirements and income limits, the interest on certain Series EE bonds (these may also be called Patriot bonds) used for education may be exempt from federal, state, and local income taxes. Also, you can exclude the interest on certain municipal bonds from your federal income (tax-exempt status applies to income generated from the bond; a capital gain or loss realized on the sale of a municipal bond is treated like gain or loss from any other bond for federal tax purposes). And if you earn interest on tax-exempt bonds issued in your home state, the interest will generally be exempt from state and local tax as well. Keep in mind that although the interest on municipal bonds is generally tax exempt, certain municipal bond income may be subject to the federal alternative minimum tax. When comparing taxable and tax-exempt investment options, you’ll want to focus on those choices that maximize your after-tax return.

In most cases, long-term capital gain tax rates are lower than ordinary income tax rates. That means that the amount of time you hold an asset before selling it can make a big tax difference. Since long-term capital gain rates generally apply when an asset has been held for more than a year, you may find it makes good tax-sense to hold off a little longer on selling an asset that you’ve held for only 11 months. Timing the sale of a capital asset (such as stock) can help in other ways as well. For example, if you expect to be in a lower income tax bracket next year, you might consider waiting until then to sell your stock. You might want to accelerate income into this year by selling assets, though, if you have capital losses this year that you can use to offset the resulting gain.

Note: You should not decide which investment options are appropriate for you based on tax considerations alone. Nor should you decide when (or if) to sell an asset solely based on the tax consequence. A financial or tax professional can help you decide what choices are right for your specific situation.

Year-end planning focuses on your marginal income tax bracket

Year-end tax planning, as you might expect, typically takes place in October, November, and December. At its most basic level, year-end tax planning generally looks at ways to time income and deductions to give you the best possible tax result. This may mean trying to postpone income to the following year (thus postponing the payment of tax on that income) and accelerate deductions into the current year. For example, assume it’s December and you know that you’re in a higher tax bracket this year than you will be in next year. If you’re able to postpone the receipt of income until the following year, you may be able to pay less overall tax on that income. Similarly, if you have major dental work scheduled for the beginning of next year, you might consider trying to reschedule for December to take advantage of the deduction this year. The right year-end tax planning moves for you will depend on your individual circumstances.

Finding a professional you trust starts here

If you would like to minimize your tax liability, contact us today at Sterling Group United. Having a financial advisor to help guide your decisions is critical and our team at Sterling Group has you covered.

The IRS Gives a Break on Flexible Spending Plans

The IRS Gives a Break on Flexible Spending Plans

The IRS has granted relief for Health 125 cafeteria plans, dependent care assistance programs and flexible spending arrangements.

Staring in Notice 2020-29, the IRS has:

  • Extended claims periods for taxpayers to apply unused amounts remaining in a health FSA or dependent care assistance program for expenses incurred through December 31, 2020.
  • Expanded the ability of taxpayers to make mid-year elections for health coverage, health FSAs, and dependent care assistance programs, allowing them to respond to changes in needs as a result of the COVID-19 pandemic.
  • Applied earlier relief for high deductible health plans to cover expenses related to COVID-19, and a temporary exemption for telehealth services retroactive to January 1, 2020.

Notice 2020-33 increases the limit for unused health FSA carry over amounts from $500 to a maximum of $550, as adjusted annually for inflation.

The rules are very specific, and each notice goes into great detail on exactly how the new rules work. Fortunately, Notice 2020-29 contains examples so those who have elected the relevant plans can see more clearly how to apply the new rules. There is also a summary of the rules  available in the IRS Newsroom.

If you still have questions regarding the new IRS rules, contact us today. Our team at Sterling Group has you covered.

Which Financial Services Are Tax Deductible?

Which Financial Services Are Tax Deductible?

When tax time rolls around, of course you want to maximize your credits and deductions so as to reduce your taxable income and avoid overpaying on your taxes. And while there are seemingly endless options for tax-deductible expenses, one area of potential that many people fail to consider is that of financial services. If you sought out financial services during the past tax year, grab those receipts and invoices, because there are a few notable expenses that you may be able to deduct on your taxes.

Financial Advisor Expenses

If you work with a financial advisor, whether it’s on an ongoing basis or was a one-time meeting, you can deduct these costs from your taxable income. This also applies if you had a financial or tax advisor assist you in preparing your taxes.

Financial Software/Program Fees

Financial or accounting programs that you purchase subscriptions to in order to track your finances throughout the year may also be tax deductible, but only during the year in which you actively paid for them. For example, if you purchased a three-year subscription to an accounting program and paid for it in the first year, you cannot deduct that cost again in the following years. If you use a program or online service to prepare your taxes, these costs would also fall into this category, so don’t forget to write them off.

Investment Management Costs

Investment management expenses for your retirement fund or any other type of investment may also be deducted on your taxes, but be careful. Commissions made by your investment managers should not be deducted, since you’re not paying for these directly our of your pocket. Still, other costs related to the management of your accounts can and should be deducted to save you on your tax bill.

Services That Aren’t Deductible

While there are plenty of financial services that are tax-deductible, be careful not to deduct anything that’s not. Some people are surprised, for example, to learn that trading commissions are not deductible. This is because they’re generally already capitalized to reduce your taxable profits. Some other financial services that are likely not deductible on your taxes can include:

  • life insurance borrowing costs
  • investment expenses related to any income that is tax-exempt
  • traveling costs associated with shareholder meetings

Knowing which financial services are tax-deductible and which aren’t can help you more confidently complete your taxes and save you some money when all is said and done. If you’re looking for further guidance on maximizing your tax deductions, reach out to our experienced professionals here at Sterling Group United.