Investing and Taxes - A Primer

This is going to be a LOOOOOOONG post, covering a ton of information about investments.  It is directly out of my book - Everyday Taxes 2015.1 - which you should buy!  As usual, I will try to cover the more common situations early, so that you don't have to read the whole section if you don't need to.  To be clear, this section is not about investments through your job, or investments in tax advantaged accounts such as IRAs.  Even with this post being quite long, I can't cover every detail of every investment.  One last thing before I go too far, I am not a financial adviser.  None of the information in this chapter is meant as investment advice or advocacy of any particular strategy, except to the extent that it impacts your taxes.  Investing should be done with thorough research on your part or the assistance of a reputable financial adviser—and that is not me.

A note for everyone: Your tax information will be reported to you on various forms of 1099s, many of which will be different from each other.  Be very careful that you get all the data from your 1099s into your tax software or onto your tax return.  If you have any doubts, have it checked by a professional, especially if you are new to investing.

Mutual Fund Investor:

If you have an account where all you do is put money in mutual funds and generally leave it there long-term (even if you shuffle it around once or twice a year) you really don't have a lot to worry about here.  If you don't already know, mutual funds are one of the most common ways that we ordinary people invest our money.  They pool our money with millions of other people's money and then invest it based on the criteria disclosed to us in the prospectus (you did read that, right).  Generally, you pay taxes on the dividends and capital gains that the mutual fund makes on your behalf, even if the money gets reinvested.  Dividends are the income that the mutual fund gets when the stocks they hold distribute some of their profits to their shareholders as cash.  Capital Gains distributions are the gains the mutual fund has when it sells some stock it owns at a profit (these are netted with stocks they sell at a loss, but if the net is negative there's no money to be distributed).  Both Dividends and Capital Gains Distributions are yours.  You can have the money sent to you on a quarterly basis, though most people simply have the money reinvested automatically in new shares of the mutual fund.  Either way, you have to report and pay taxes on these on your return.  Your investment company will send you a 1099-DIV (though they may send you a combined 1099 if you have other investments besides mutual funds, or you sell or exchange funds, but it will have the same information).  The 1099 will report your dividends, qualified dividends (dividends that get a lower tax rate), and capital gain distributions.  These are all reported directly into your software or directly on your Form 1040, Schedule B and/or Schedule D, and are fairly straightforward and easy to handle.

If you sold one mutual fund, even if just to move the money into a different mutual fund, they will send you a 1099‑B.  This will list your "proceeds from broker or barter transactions."  This is a complicated way of saying, "how much you got for selling something."  The key is that you need to report this, even if you sold it for EXACTLY (or less) than what you paid for it.  Many times, the IRS gets just the amount you sold it for, not the amount you paid for it.  You only pay taxes on what you made (difference between price paid and price sold), but the IRS may not know what you paid for it, so if you don't report it, they'll send a letter demanding an amount of taxes based on the full proceeds.  This wrinkle is the source of many a jaw-droppingly scary letter from the IRS.  The biggest problem for some people is figuring out just what you paid for it, especially if you only sold a portion.  The good news is that many brokers are providing this information (it's required to be on the form they send you if you purchased it in the last couple years, so this is getting easier every year).  If the information is not on the 1099, you can either get it by reviewing the statements from when you purchased it (and every statement between then and the sale, since you add dividends and capital gain distributions to basis), contact your broker for help, or bring your records to your tax professional.  I will add that if you are paying a full service broker, they should be doing this for you.  They may need records from a previous broker, but I would demand this from them.

The last couple of things you might see on your 1099 are "Non-dividend Distributions" and "Foreign Taxes Paid."  Non-dividend distributions are essentially a return of the money you invested in a company.  They are tax neutral, but they reduce the amount you "paid" for a mutual fund, and will increase your gain when you sell.  Hopefully your investment company is tracking this for you.  You will generally see Foreign Taxes Paid when you invest in a fund that invests outside of the United States.  This represents your portion of the taxes the mutual fund paid to foreign governments.  You can get these taxes back on your tax return as a Foreign Tax Credit.  If they are from mainstream mutual funds, you generally file a simplified version of Form 1116 and the taxes come back to you.

Individual Stock Investor:

The first warning I'll give you is to either make sure the companies you are buying are actually corporations, or be prepared for the craziness that ensues from investing in non-corporations.  What I'm talking about are Real Estate Investment Trusts, Limited Liability Partnerships and the like.  Thanks to technology, you can pop onto an investment web site and buy these just like a regular stock from a corporation.  The old classic example would be Kinder Morgan Energy Partnership.  You could buy a share in the partnership just like it was a stock, but late in the tax season (sometimes after filing your taxes) you get a Schedule K-1 representing your share of the various items from the partnership's tax return.  This quite complicated form can drive you crazy and almost certainly requires a tax professional to file.  This is not to say that these aren't great investments, many are, but you need to know what you are getting into.  For the record, I believe Kinder Morgan has converted itself to a traditional corporation. 

Having said that, the main differences between a mutual fund investor and an individual stock investor is that you won't have capital gain distributions, and you might get 1099-DIVs and 1099-Bs individually for your stocks, or combined depending upon your investment company.  When you invest in individual stocks, you only pay capital gains when you sell the individual stocks.  It's also a lot easier to track basis since you don't have to track capital gain distributions.  The separate or combined forms for 1099-DIV and 1099-B don't significantly impact how they're reported, other than using more lines on Schedule B, Schedule D or form 8949.  Do be aware that anytime you sell an individual stock, you will have to report it on your tax return and pay taxes on the gain (or deduct some or all of the loss—capital loss deduction is discussed below).

Day-Trader:

I'm not really interested in going into a huge amount of details on this, but the big thing to point out is that usually, EVERY single stock transaction needs to be reported on your Form 8949.  As a guy whose done tax returns for day traders with thousands of transactions, this sucks.  What you can do now is, if the investment company reports the basis to the IRS, you can do one line for combined short-term sales (less than one year from purchase to sale) and one line for long-term sales.  You can tell the basis has been reported to the IRS because those transactions will be separated from the other transactions on the 1099-B.  The form will specifically say that the transaction’s basis is reported to the IRS.  You will need to send a copy of the 1099-B to the IRS, either with your mailed-in tax return, or attached to Form 8453 if you are electronically filing.

Read if you sold ANYTHING (or you get a 1099-B): 

I kind of talked about this already, but it's important enough to reinforce.  If you sell or exchange a mutual fund or stock, you should get a 1099-B.  If you get a 1099-B, you absolutely MUST report it on your tax return, even if you broke even or lost money.  Tons of terrifying IRS letters are generated from people not reporting transactions because "I didn't make any money."  The problem is that the IRS may not know you didn't make any money.  You need to TELL them you didn't make any money, by reporting the transaction on your tax return.

Capital Gains and Losses:

As discussed above, when you sell a stock or a mutual fund, you may have a gain or a loss.  On tax returns, you need to separate these gains and losses based on "holding period."  Basically, if you bought the stock or fund more than a year before selling it, it's long-term.  Less than a year ago, it’s short-term.  The capital gain distributions we talked about from mutual funds are assumed to be long-term.  Later I will clarify holding periods for weird situations.  So now what you do is net your long-term gains and losses and your short-term gains and losses.  If you have short-term gains that exceed your losses, you pay taxes at your normal rate.  If you have long-term gains that exceed your losses, you pay taxes at a lower rate, depending on your income.  If they net to a loss, you can deduct some of that loss, and carry over the rest to your future tax returns. It will then be your starting point for long-term or short-term capital gains or losses.  The amount of loss you can deduct in the current year is $3,000 ($1,500 if you are MFS).  If your gains are long-term, they are taxed at a maximum rate of 23.8%.  The great news is that if you are in the 10% or 15% tax bracket, they are taxed at ZERO!  Keep in mind that your tax bracket is based on your income including your capital gain, so don't go overboard selling stock because you think you will be in the 15% tax bracket.

Wash Sales:

A wash sale is an IRS term that is specifically designed to prevent you from selling a stock that is currently losing money, solely for the purpose of generating a taxable loss.  As long as you sell the stock and don't re-buy it, you're good.  If you buy it back within 30 days of selling it, you essentially ignore the sale for tax purposes.  You report it, but don't take the loss; your basis (purchase price) remains the amount you originally paid for it.  This only applies to assets sold at a LOSS.

Reverse wash sale (not a real term):

A reverse wash is my made-up term for selling and buying stock back to eliminate gains from potential taxation. First and foremost, if you are not in the 15% tax bracket or below, stop reading.  This won't work for you.

If you are, then you can cash in appreciated stock or mutual funds at a 0% tax rate so long as the gains do not put your taxable income above the 15% tax bracket.  You can then immediately buy the same stock back (if you want) and the new price will be what is later used to figure gain when you sell it again.  You can do this every year and effectively eliminate gains from potential taxation!  This is why I call it the reverse wash sale.  Wash sales only apply to losses, not gains.

Here is a list of things to consider when determining if it's worth contacting your tax professional for help on this:

                1. For 2015, your taxable income should be several thousand dollars below: $37,450 if filing Single, $74,900 if filing MFJ, $50,200 if filing HH (taxable income is basically your income after all adjustments for deductions and exemptions).

                2. You have unrealized gains in taxable brokerage accounts or mutual funds that you have held for more than a year (in most cases this means you have stocks or mutual funds that are worth more than you originally paid for them)

                3. You're not under age 19 (24 if in school).

                4. You're not receiving Earned Income Credit on your tax return.

                5. You're not receiving Social Security payments (if this is most of your income you might still benefit).

                6. You don’t have a capital loss that you are carrying over.

                7. Buying and selling stocks or mutual funds in your taxable accounts doesn't cost too much in commissions

Much of the above involves over-simplifications, but it gives you a starting point to see if you might be close.

If the above apply to you, wait until mid-November, and contact your tax professional.  Provide them with copies of your recent pay-stubs from all your jobs, as well as amounts of any other taxable income you have or expect to receive before the end of the year (interest, dividends, capital gains, etc.)  They should be able to calculate how much gain you can have and still pay 0 taxes on it.  Don't worry if it's not perfect, even if you go over a little, only the portion above the 15% tax rate gets taxed, and this at a favorable rate.  Once you have this number, review your unrealized gains and losses information from your brokerage account and determine what to sell to stay below the number they provided.

You can do this every year you are in the 15% tax bracket!

The rest of the details:

Municipal Bonds:  When you buy bonds from states, cities or other municipalities, they are exempt from federal taxation. Most states exempt their own bonds from taxes, but tax other states.

Schedule K-1:  These look very complicated, but the principal is that everything from a Schedule K-1 has a place on a regular tax return.  They come with instructions that tell you where to put them. The most confusing part is that the information can carry to some incredibly complex tax returns, which means that often the most confusing part is realizing that some of the information doesn't actually carry to your tax return.

Original Issue Discount (1099-OID): As long as you don't buy bonds on the secondary market, OID (original issue discount) interest is just interest.  What makes it weird is that you buy a bond at a discount to its ultimate price, and the difference between what you paid and the final price is interest, or OID.  You pay taxes on the interest as it accrues, not when you finally cash in the bond.  The 1099-OID gives you the right amount of interest to report on your return.

United States Savings Bonds: These differ from normal bonds in that you are allowed to wait to pay taxes on the interest until you cash the bonds in.  There are also exclusions on taxability of interest if you use the proceeds for education (see the I’m Going to College section for details).  Also, all US Treasury bonds and bills are exempt from taxation by the states.

Inherited and Gifted Investments: The only real change between inherited or gifted assets is how we determine your basis (cost) in the investment for gain purposes.  For inherited assets, your basis is the basis on the date of death (and the assets are assumed to be held long-term).  For gifted assets, the person who gave them to you has a basis, and that basis transfers to you.  The long-term or short-term determination begins on the date it is given to you.

Puts and Calls: These are advanced investment vehicles where you’re buying the right to buy or sell a given security at a later date at a specified price.  The main effect of these instruments is on basis and proceeds amounts. If your investment company doesn't provide this information, you should seek help in determining it until you fully understand its effects.

Short Sales: Short sales are investments where you are betting that an asset's price is going to decrease.  You borrow the asset from your broker and sell it, hoping to buy it back at a lower price to return it.  If you buy it back at a lower price, the difference between the borrowed price and bought back price is a gain.  If you are forced to pay more money for it than the price you sold it for, the difference is a loss.

Specified Private Activity Bonds: These are strange bonds that straddle the line between private and government.  They are specifically identified and are generally tax free.  If you are subject to Alternative Minimum Tax (see that section) they are taxable.

You receive income that's not really yours (nominee dividends):  If for some reason you receive a 1099 reporting interest or dividends as your income, but it's really someone else's, seek professional help to unravel this.

Affordable Care Act Net Investment Income Tax: If you make above certain income thresholds, your total net investment income (income = gains – losses) is subject to an extra 3.8% tax above and beyond income and capital gains taxes.  The thresholds are: $250,000 for MFJ and QW, $200,000 for HH and Single, $125,000 for MFS.  The 23.8% maximum rate discussed previously in this section includes this potential 3.8% addition.