A couple posts ago I mentioned that when mutual funds and ETFs invested in stocks are infrequently traded, there is a tax advantage compared to normal wage income. I’ll be discussing this very important fact today.
First, we need to define a couple things
Cost basis – The price at which you paid for a capital asset (such as stocks, bonds, and real estate).
Capital gain – The difference in the sale price and the cost basis
Long term capital gain (LTCG)– In the context of purchasing stocks, ETFs, and mutual funds, a capital gain from an asset that has been held for at least a year (this one year period may change in other contexts – I’m not sure about that).
Short term capital gain – A capital gain from an asset that has not been held long enough to be classified as a long term capital gain.
Dividend – A payout of a portion of a company’s earnings to shareholders.
Qualified Dividends – A dividend that is taxed at the LTCG rate. For a dividend to be qualified, it should come from a stock or mutual fund or ETF holding a stock. Bond and REIT mutual fund dividends can never be qualified dividends. The asset providing the dividend must be held for at least 60 days within the 121 day period centered around the dividend distribution date.
Just like you are taxed on income, you are taxed on your capital gains (your profit from buying an asset). Short term capital gains are taxed at the same rate as normal income. However, long term capital gains are taxed at a lower rate than short term capital gains (presumably because the government wants to encourage investment). Here’s a table on the tax rates:
|Normal income tax rate||Long term capital gains rate|
*Because of Obamacare, there is an additional 3.8% tax on all investment income once a taxpayer’s AGI exceeds $200k for single or $250k for MFJ.
Yes, you read that right. There are 0% tax brackets on LTCG’s! The lower tax rates on LTCGs is one of the ways that makes it easy for the rich to get richer. And you can take advantage of this too by investing and holding your funds for at least a year.
Now it can get a little tricky to figure out the marginal tax rate that actually gets applied to your investment income if you also have other income taxed at the normal rate. So, this is where the bucket of water analogy comes in handy.
Take Bob from my last post – he made $80,000 from his job. He’s single, has no children, and does not itemize his deductions. Now assume he also has $10,000 of LTCG. Imagine filling a new bucket, where you fill in $80,000 of water and $10,000 of oil. The oil floats on top, like this
(Recall that the de facto 0% bracket is created by the standard deduction and exemption).
So in this scenario, all of his LTCG are in the 25% normal marginal bracket, meaning his LTCG will be taxed at 15%.
What if instead Bob made $44,000 from his job? Well, now the picture looks like
In this scenario, $47050 – $44000 = $3050 of his LTCG is taxed at 0%, and the next $6950 of his LTCG is taxed at 15%.
Long term capital gains are a much more tax efficient way to make money than working – not only is your federal income tax rate lower, but remember, wage income is also subject to FICA tax (7.65% on the first $117,000, and 1.45% thereafter). Now, at the state level, it appears that most states do not have a lower tax rate on capital gains – but I could be mistaken. Check your state’s tax code.
Qualified dividends are taxed at the same rates as LTCG and “float” on top of normal income the same way that LTCG “floats” in calculating tax rate.
What if you sell your capital assets for a loss? Well, initially you use the capital losses to cancel out any capital gains you had during the year. First, short term losses cancel out any short term gains. Also, long term losses cancel out long term gains. After that, you combine short and long term losses and gains. If there is still a loss, you use up to $3000 of that capital loss as a tax deduction. Any capital losses remaining are carried forward indefinitely into future tax years to cancel out future capital losses and/or deduct $3000 at a time from your income.
Tomorrow I will talk about tax loss harvesting. which involves purposely selling your investments at a loss for the tax benefits (but the benefit of this is always lower than your actual capital loss – so this doesn’t mean you should purposely pick funds that you think will perform terribly).
Note: Although qualified dividends and LTCGs are taxed at the same rates, you do not combine qualified dividend income with capital losses and gains in calculating how much of a capital loss you an deduct from your income. For example, if you had $3500 in capital losses and $1000 in qualified dividends, then you can deduct $3000 from your income, carry forward $500 in capital losses, and you still report $1000 in qualified dividends. You do not combine the capital losses and qualified dividends to result in a $2500 deduction from your income and no capital loss carryforward.
Cost Basis Methods
Remember, your capital gain is defined as the difference between the cost basis and sale price. There are several methods of keeping track of your cost basis. For the examples below, assume on 1/10/2010 you bought 20 shares of VTSAX at $30, and on 6/10/2010 you bought 20 shares of VTSAX at $50.
- Average basis – You average the cost of all the shares. When you go to sell your shares, all shares have a cost basis of $40 (because ($30*20 + $50*20)/(40 shares) = $40/share).
- First in First out (FIFO) – As you start selling shares, you use the purchase price of the first share bought. So if you sell 20 shares, you are selling shares with a cost basis of $30. If you sell another 20 shares, those shares have a cost basis of $50.
- Last in First out (LIFO) – the same as FIFO, but you reverse the order of shares
- Specific identification -You identify exactly which shares you are selling at the time of the sale. So if you desire, you could sell 20 shares by saying 10 of those shares are the ones bought on 1/10/2010, and another 10 of those shares were bought on 6/10/2010.
Before January 1, 2012, you were responsible for keeping track of the cost basis of all of your shares of mutual funds, stocks, and ETFs. Starting on 1/1/12, the IRS mandated that brokerages keep track of all this information for you (because they thought they were getting cheated out of tax revenue). Hence, for any shares you purchase today, there is absolutely no burden on you to keep track of the cost basis.
For any shares you bought after 1/1/2012, you should definitely use specific identification of shares as your cost basis method (and for shares bought before 1/1/2012, you should do your best to use specific ID). Here’s why.
Suppose you need $800 and you plan to get this by selling some of your shares of VTSAX. Currently, the price of VTSAX is $40. If you use average basis, your capital gain is 0, as all shares have a cost basis of $40. But, if you use specific ID, you can identify the shares bought 6/10/2010 as the shares you are selling, and you have a capital loss of $200, which you can deduct from your taxes. Now keep in mind, in each scenario, you still end up with $800 in your bank account. Don’t let the term “capital loss” scare you into thinking you somehow lost more money with the second scenario than the first.
In that example, LIFO would have resulted in the same tax consequences as specific ID. However, there are certainly more complications in situations with many tax lots. In such scenarios, specific ID will be the best method. With specific ID, you can always choose the highest cost basis shares and minimize your capital gain.
Next time I will talk about tax loss harvesting and capital gains distributions from mutual funds.