This note summarizes:

  • Types of investment instruments and the taxes that apply to them.
  • Taxed advantaged accounts available in the US and what investments make best use of them.
  • Tax saving strategies related to investing.

Types of Investment Accounts

Tax can be due either before investing money in the account, or during withdrawal.

  1. No tax at all

    • HSA or Health Savings Account

      Money can be withdrawn at any time for valid medical expenses upon availability of bills or at retirement.

  2. Tax Deferred Accounts

    No tax during contributing, taxed upon withdrawal

    • 401k Account

      Withdrawal upon retirement or a 10% penalty for early withdrawal.

  3. Tax Free Accounts

    Contributions are taxed, no tax during withdrawal

    • 401k ROTH account

      Needs the employer to allow it.

    • ROTH IRA account

      Yearly contributions of up to $6000.

  4. Fully Taxed Accounts

    • Brokerage account

Types of Taxes

Capital Gains

Realized only upon selling the investment that has increased in value.

  1. Short term capital gain
    • Same as income tax.
    • Applies when the stock was purchased and sold in under a year.
  2. Long term capital gains.
    • 0%, 15% or 20% based on tax bracket.
    • Applies on stocks that were held for more than 1 year.

Dividend

  1. Qualified Dividend
    • Tax rates of 0%, 15% or 20% based on tax bracket.
    • Dividend of American corporation or corporations domiciled in countries with tax treaty with the US if stock held for more than 60 days becomes qualified dividend.
    • Less tax is paid because a company has already paid taxes on these profits, unlike pass-through entities which give away all the profits as is to the shareholders.
  2. Unqualified Dividend
    • Income tax rate.
    • All interest falls in this category. This is the default for all earnings unless specified as Qualified.

Reported by the IRS on Form 1099-DIV

Bonds Issue Discount

Bonds sold at a discount from their par value, like 0 coupon bonds, will be taxed at ordinary income tax rates by the difference in the price.

Capital Losses

  • $3000 in losses against all income can be deducted, more can be rolled over over the years
  • Long or short term capital losses are used to offset gains in the same categories, and if they exceed can then apply to the other.
    • Ideally, use short term capital losses because they are taxed at a higher rate and carry them over to future years instead of applying them to long term capital gains.
    • Carried over capital losses are applied to ordinary income, taxed at same rates as short term capital gains.
  • Links

Investments and Tax Treatment

Arranged in increasing order of risk (and therefore, return).

Liquid Money

  • Checking Account
    • Income tax, but it doesn’t make you any money at all.
  • Money Market Funds
    • Only to temporarily hold money ideally. Almost no capital appreciation by design.
    • Can be taxable (Are treasuries, so only Federal) or tax free (investing in state assets). Check underlying.
  • Savings Account
    • For emergency fund
    • Taxed as ordinary income tax
    • Check if Treasury yields are higher.
    • Reported on Form 1099-INT
  • Treasuries
    • Treasury Bonds (30 years), Treasury Notes (2 to 10 years) and Treasury Bills (4, 8, 13, 26 and 52 weeks)
    • Taxable only at Federal level, not state.
    • Generally matches inflation but extremely safe.
    • Account to use: Brokerage Account, Tax Deferred Account, Tax Free Account.

Slightly Higher Risks

High Risk

  • Mutual Funds
    • Taxes are similar to the taxes applied to stocks that the fund holds.
    • The fund’s activity of selling underlying assets can trigger short term capital gain even if you held the fund for longer. This is interesting in the following cases
      1. If the fund actively buys and sells underlying stocks
      2. During a sell-off, the holders of the fund can become potentially liable for tax on distribution income generated on sale of assets.
    • Dividend rules for Mutual funds are similar to stocks they consist of; taxed at ordinary income, qualified dividends or tax free dividends.
    • This is the reason why calculating how much one owes in taxes for mutual funds can get complicated.
    • Account to use: Tax Free Account, Tax Deferred Account
    • Links
  • ETFs or Electronically Traded Funds
    • Taxed just like the underlying stock or bond, including their dividends.
    • For selling, 1 year rule applies for long term capital gains
    • For dividends, ordinary or qualified dividend rules apply.
    • Accounts to use: Tax Deferred Account, Tax Free; assuming held long term.
    • Links
  • Dividend Stocks
    • Taxable dividend: Qualified v. Ordinary/Unqualified
    • Account to use: Tax Deferred Account, Tax Free Account.
  • Growth Stocks
    • Taxed either short term capital gains or long term capital gains if there’s a gain on the price of the stock.
    • Short term v. long term capital gains
    • Account to use: Tax Free Account, Tax Deferred Account; can be interchangeable based on growth potential.
  • REITs or Real Estate Investment Trusts
    • Taxed as regular income as they are a pass-through entity, but you can deduct 20% of the income.
    • Sale of real estate by the trust is passed on as capital gains.
    • It gets trickier with depreciations.
    • Account to use: Tax Free Account, Tax Deferred Account
    • Links
  • BDC or Business Development Companies
    • Regulated Investment Companies (RIC) that use their capital to load or buy stake in small and mid sized private copmanies.
    • RICs need to pass at least 90% of the income so they pay no tax. Income therefore is taxable at income tax rates.
    • Accounts to use: Tax Free Account.

Insane Mode

  • Options
    • It’s complicated! I’ll update as I learn more about options.
    • Types
      1. Pure Options Play
        • Short term gains tax irrespective of how long they are held.
        • Applies to both long and short options.
        • Gains or losses calculated when they are sold or expire
        • Options on Index (example: S&P 500, Russell 2000) are treated as 60% long term gains, 40% short term.
      2. Covered Calls
        • Short term gains on option sold, if it expires.
        • If call exercised, taxes apply as if one were selling their stocks.
        • Call bought back, it’s short or long depending on the time duration.
      3. Protective Puts
        • Depends on when it was bought.
    • Accounts to use: Where stocks sit for covered calls, Brokerage to harvest the losses, Tax Free otherwise. Tax deferred account do not support options.
    • Links

Investment Account Preference for Investing

Ideally, the preference for all investments would be:

  1. No Tax At All Account
  2. Tax Free Account
  3. Tax Deferred Account
  4. Brokerage or Fully Taxed Account

This is not always possible as the size of the tax advantaged accounts are limited.

We should prioritize the instruments with the highest tax responsibilities in the tax advantaged accounts and investments that have tax advantages built in to go to the brokerage accounts.

  • Highest Taxed Investments
    1. Bonds
      • Corporate Bonds that pay high yields
      • Doesn’t apply to Government bonds are an exception because they have ‘some’ sort of tax advantages and generally have lower interest rates.
    2. Non Qualified Dividend Paying Investments
      • Taxed at income tax, investments like foreign bonds and investments.
    3. Short Term investments
      • This one’s tricky especially for dividend yielding stocks as they become qualified in 60 days unlike capital gains which takes a year.
      • Generally though, if an investment is only temporary, it may make sense to trade that in a tax advantaged account.
    4. Options
      • Most cases are taxed at short term gains. This one is complicated because chances of losses are also high, and one may want to take advantage of tax loss harvesting.
  • Tax Advantaged Investments
    1. Municipal Bonds
      • Owe no taxes on munis in the state you’re living in potentially. Even if not, you only owe state taxes which are lower than Federal taxes.
    2. Treasuries
      • Only owe Federal taxes, so keep the tax advantaged accounts free for other investments.
    3. Dividend Paying Stocks
      • Only those who pay Qualified Dividends, the tax rate is that of long term capital gains and therefore lower than income tax levels.
    4. Long Term Stocks
      • Both Dividend that becomes qualified and potentially having to pay long term capital gains means you pay lower taxes when you sell them.

These are arranged in the order of should-be to maybe. So the latter investments can jump account preferences based on balances.

Between Tax Free Account and Tax Deferred Accounts, keep the ones with the highest growth or yield potential in the tax free while paying conservative in the tax deferred account know that you will owe taxed on those balances.