Understanding taxes on your investment accounts

At this time of year many Americans are thinking about taxes. Even if you’ve already filed your 2016 returns, it’s a good idea to start thinking about next year. We know that figuring out taxes on your investments can be confusing, so here are some things you should know.

 

Understand the taxes you pay on investment income

When you sell a stock or mutual fund at a profit, you will usually get taxed. If you sell within the first year you own that security you’ll pay tax at ordinary rates, which could be as high as 39.6% depending on your income level. But the tax code is designed to encourage long-term investing, so if you hold that same security for longer than a year, you’ll pay a lower rate — a maximum of 20% for most stocks and funds.

Strive for long-term investing in taxable accounts and minimize frequent trading whenever possible. Keep in mind that you’ll also pay tax on mutual fund distributions even if you don’t sell any shares of the fund yourself. When the portfolio manager sells some of the fund’s holdings, as happens in the normal course of managing the fund, the taxable gains are passed on to you. This is also true for other actively managed portfolios like wrap accounts.

To calculate the capital gain or loss when you sell a security, you must know your cost basis for that security. The cost basis is your original purchase price for the security adjusted for stock splits, dividends, and return of capital distributions. If you sell a security for more than your adjusted cost basis, you will realize a capital gain. If you sell a security for less than your adjusted cost basis, you will realize a capital loss.

Capital gains and losses must be reported on your tax return (generally on Schedule D of Form 1040). You’ll need to know your adjusted cost basis, the realized gain or loss from each security, how long you owned the security (short term or long term), and the type of assets involved. This information is usually provided to you by your broker; it may be summarized on a consolidated 1099 form with your dividend information. Keep in mind that in addition to Schedule D, you’ll need to report every transaction to the IRS on Form 8949. For our wrap clients, this form is prepared for you by our broker; all you need to do is attach it to your tax return.

 

Don’t forget your dividends and other income

In addition to profits from selling investments, you pay tax on dividends you receive from your investment accounts. Qualified dividends on stocks and stock mutual funds are eligible for the same lower maximum 20% rate. However, income received on most bond funds — and on the Azzad Wise Capital Fund — are taxed at ordinary income tax rates. All dividends (and interest) are reported on the Form 1099 and must be reported on your tax return.

 

Maximize your tax advantaged accounts

Of course, not all investments are taxable. Be sure to take advantage of tax deferred retirement accounts like traditional IRAs and 401(k) accounts. They can help reduce your taxable income as you benefit from tax-deferred growth. Even a nondeductible traditional IRA can go a long way towards helping you build your retirement nest because any earnings grow tax free until you retire. Keep in mind you’ll report any nondeductible IRA contributions on Form 8606.

Roth IRAs are another way to help you save. Unlike other retirement accounts, you do not report your Roth contributions on your tax return. Although your Roth contribution will not reduce your taxable income, you still benefit from tax-deferred growth. Moreover, the earnings will be tax-free when you withdraw them at retirement age.

Bear in mind there are income eligibility requirements for a Roth. If your income is too high to directly contribute to a Roth IRA, you may benefit from a “backdoor” Roth conversion in which you contribute to a nondeductible IRA and then quickly convert it into a Roth IRA. This process can get tricky, so you should consult with your tax advisor before doing a backdoor Roth contribution.

Earnings held in other accounts such as Coverdell Education Savings Accounts also grow tax deferred and are tax-free when withdrawn to pay for qualified education expenses. On the other hand, custodial accounts such as UTMAs are treated like any other investment account and you must report any dividends along with the cost basis on your tax return.

Withdrawals from a retirement account are reported on Form 1099-R, and you must report them on your tax return. Depending on your situation, those withdrawals may or may not be taxable. If you are under age 59½, you may also incur an early withdrawal penalty.

 

Consider harvesting losses

Afraid you may be looking at a sizable tax bill on your investments this year? You may want to consider harvesting your losses. This is a common technique in which an investor intentionally realizes losses to try to offset gains in the year. However, be careful of the IRS’s wash sale rule, which prohibits investors from claiming a loss on securities sold in a wash sale. A wash sale occurs when you, your spouse, or an entity you control (such as a business) sells a security at a loss and purchases it or a “substantially identical” security again within 30 days. This counts across all taxable accounts.

Because your situation is unique, we strongly advise you to consult with a tax professional.

Tax trivia: U.S. federal income tax became permanent in 1913 with the ratification of the 16th Amendment to the Constitution. Also in 1913, the first Form 1040 was created. Back then, less than 1% of the U.S. population made enough money to have to pay federal income tax. These days, nearly 55% of Americans pay federal income taxes (Tax Policy Center, 2015).

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