Kavan Choksi Sheds Light on Tax Basics for Investors

All investors need to keep in mind that federal government taxes are not just investment income, like rent on real estate, interest and dividends, but also realized capital gains. Kavan Choksi mentions that the holding period matters a lot while calculating capital gains. Long term investments are subject to lower tax rates, and interest income from investments is generally treated like ordinary income for federal tax purposes.

Kavan Choksi talks about tax basics important for investors

Companies pay dividends out of after-tax profits. This means that the taxman has already taken a cut, and therefore the shareholders get a break. They ideally enjoy a preferential tax rate on “qualified dividends” in case the company is domiciled in the United States or in a nation that has a double-taxation treaty with the USA acceptable to the IRS. Entities that receive non-qualified income like a dividend paid from interest on bonds held by a mutual fund or non-qualified dividends paid by other foreign companies tend to be taxed at regular income tax rates.  Shareholders, however, benefit from the preferential tax rate only if they have held shares for at least sixty one days during the 121-day period that starts 60 days before the ex-dividend date. Any days on which the risk of loss of the shareholders is diminished do not count toward the minimum holding period. Investors may cut down the tax amount by holding assets like taxable bond mutual funds and foreign stocks, in a tax-deferred account like an IRA or 401(k) while keeping the domestic stocks in the regular brokerage account.

The federal government treats most interest as ordinary income subject to tax at the marginal rate paid by the investors. Even zero coupon bonds cannot escape this task. While investors do not receive any kind of cash till maturity with zero-coupon bonds, they do have to pay tax on the annual interest accrual on these securities. This tax is calculated at the yield to maturity at the date of issuance. Kavan Choksi points out that the interest on bonds issued by USA states and municipalities are however an exception. Most of these bonds are exempt from federal income tax as well. Investors can also get a break from state income taxes on interest by choosing to invest in municipal bonds.

 Investors who are subject to higher tax brackets usually prefer to hold municipal bonds instead of some other types of bonds in their taxable accounts. Whole the municipalities do pay lower nominal interest rates than corporate of equivalent credit quality, the after-tax return to these investors generally is greater on tax-exempt bonds.

It is important to understand that investors cannot escape taxes by choosing to invest money indirectly through limited partnerships, real estate investment trusts, mutual funds and exchange-traded funds. The tax character of their distributions tends to flow through to investors, who are still liable for tax on capital gains as they sell. Short-term capital gains are taxed at regular income tax rates, which are usually typically higher. Short term here implies to less than one year of valid holding period.