3. Investment Planning. 17. Taxation of Investment Vehicles Flashcards
An important consideration when evaluating any investment or comparing multiple investments is calculating the effect of taxes on the rate of return. Comparison of investment returns is only effective if done on an after-tax basis. There are some investments that are taxed by the federal, state and local governments, while others are only taxed by the federal government or state and local government and still others that are completely tax exempt. Understanding how different investments are taxed is important, not only to make sure the investor is appropriately meeting his or her tax obligations, but also to create an investment plan that is tax efficient.
The Taxation of Investment Vehicles module, which should take approximately two and a half hours to complete, will explain the tax considerations associated with various investment vehicles.
Upon completion of this module you should be able to:
* Explain the tax consequences of investing in U.S. government bonds, municipal bonds, zero coupon bonds and agency bonds,
* Describe the tax considerations associated with treasury inflation-protection securities,
* State the tax treatment for dividends and capital gains and losses,
* Explain the tax consequences due to liquidation of stocks,
* List the methods for determining cost basis of stocks,
* Define stock rights,
* Explain distributed capital gains for mutual funds,
* Describe the tax consequences for U.S. savings bonds,
* Explain the taxation of annuities, and
* Describe of taxation of limited partnerships.
Module Overview
In general, if a person sells or trades an investment property, a holding period must be determined for the property. To determine how long an investment property has been held, begin counting on the day after the date the property was acquired. The day the property was disposed of is also needed to determine the holding period. The holding period determines whether any capital gain or loss was a short-term or a long-term capital gain or loss. If a person holds investment property for more than one year, any capital gain or loss is a long-term capital gain or loss. Conversely, if the property is held for one year or less, any capital gain or loss is a short-term capital gain or loss. Long-term capital gain is taxed at a lower rate than short-term capital gain. Long-term capital gains carry a maximum tax of 20% while short-term capital gains are taxed at ordinary income rates with a maximum rate of 37% (2019). Investment income may also be subject to an additional 3.8% Net Investment Income Tax if the taxpayer’s modified adjusted income exceeds certain thresholds. The other taxable item that applies to most securities is the income derived. For stocks and mutual funds, such income comes in the form of dividends. For bonds and money market instruments, that may be interest or coupon payments
The capital losses incurred on the sale of a security, either short-term or long-term, can be used to offset the corresponding capital gains. If any capital losses remain after offsetting all the capital gains, this amount can be used to reduce ordinary income by up to $3,000 per year. If any losses still exist in excess of that amount, they can be carried forward to following years indefinitely with a maximum of $3,000 per year to reduce capital gains or ordinary income.
To ensure that you have a solid understanding of the taxation of investment vehicles, the following lessons will be covered in this module:
* Taxation of Bonds
* Taxation of Stocks
* Taxation of Mutual Funds
* Taxation of Other Investments
Audio:
One thing is certain in investment planning - eventually will have to determine taxes owed to IRS.
Important to be aware of taxes associated with various investment vehicles in order to select the right investment, to efficiently manage the clien’ts portfolio for after tax returns, and not overlook money owed to IRS
Module will give overview of taxes associated with stocks, bonds, mutual funds and other investments
Goal is to help recognize tax consequences should play a role in investment selection and trading decisions
Section 1 – Taxation of Bonds
Bonds are commonly used as investment vehicles. The person who buys a bond lends money - the par value of the bond - to the issuer, usually a corporation, the federal government and its agencies, a city or a state. In return for the use of the money, the issuer pays interest, either periodically or compounded into the maturity value of the bond. Typically, corporate bonds’ coupon payments are taxable as ordinary income. If the bondholder sells the bond for a profit before it matures, it would be subject to capital gains tax. Federal and Municipal government issued bonds may have certain tax-exempt features associated with the coupon payments.
To ensure that you have a solid understanding of the taxation considerations for bonds, the following topics will be covered in this lesson:
* U.S. Government
* Agency Bonds
* Municipal
* Zero Coupon
* Treasury Inflation-Protection Securities
Upon completion of this lesson, you should be able to:
* State the tax consequences of investing in U.S. Government bonds,
* Explain the taxation of Agency bonds,
* Describe the tax consequences of municipal bonds,
* Define the taxation of zero coupon bonds, and
* Specify the tax consideration for treasury inflation-protection securities.
Sidney purchased a long-term bond fund last year. She received a statement at the end of the year that told her a portion of the income she received from the fund is tax-free at the state level. Which of the following types of bonds in her fund may exempt income from state taxes? Click all that apply.
* T-Notes
* Corporate Bonds
* T-Bonds
* High Yield Bonds
T-Notes
T-Bonds
* U.S. government bonds such as treasury notes and bonds and agency bonds are direct obligations of the U.S. government and have income that is exempt from state taxes.
Which of the following types of capital gains are NOT tax exempt?
* Original Issue Discount
* Market Premium
* Original Issue Premium
* Market Discount
Market Discount
* Market discounts are not exempt from taxes. When someone purchases a bond in the secondary market at a discount and sells it at a higher price or lets it mature, there is taxable capital gain.
Section 1 – Taxation of Bonds Summary
Bonds can be divided into three categories of issuers: Federal government, municipalities, and corporations. Federal government direct obligation bonds such as U.S. Treasuries and GNMAs are typically not subject to state income taxes (the method of tax-exemption calculation is different from state to state). Municipal bonds are tax-exempt from federal income taxes. Corporate bond coupon payments are taxable both at the state and the federal level. All bonds, no matter the issuer, are subject to capital gains taxes if the bondholder sells the bond prior to maturity for a gain. The same rules apply to bond funds made up of these bonds.
In this lesson, we have covered the following:
* U.S. Government Treasury bonds are issued by the federal government. The interest earned on these bonds is subject to federal tax but not state and local income taxes.
* Agency Bonds are issued by agencies of the federal government. The interest payments from these bonds are taxable for federal tax purposes, but not for state and local income taxes.
- Municipal bonds are issued by state or local governments. The interest paid is exempt from federal income tax and usually from state and local taxes as well. However, the capital gains from the sale of a municipal bond might be subject to tax and the interest earned from a municipal bond is included for AMT calculation purposes. Some municipal bonds are designated to be subject to AMT.
- Zero Coupon bonds are issued by federal, state and local governments. The accrued interest from zero coupon Treasury bonds is subject to federal income tax and exempt from state and local taxes. The accrued interest from zero coupon municipal bonds is not subject to federal income tax but they may be subject to capital gains tax if sold before maturity.
- Treasury Inflation-Protection Securities issued by federal government - pay interest every 6 months based on a fixed coupon rate applied to an inflation adjusted principal amount. The interest paid is exempt from state and local taxes just as other Treasury Notes and Bonds. TIPS investors pay Federal taxes on the interest paid annually, as well capital gains tax on the growth in principal in the year that it occurs.
Which of the following are subject to federal tax with respect to interest earned on them? (Select all that apply)
* Treasury bonds
* Agency bonds
* Municipal bonds
* Inflation-protection bonds
Treasury bonds
Agency bonds
Inflation-protection bonds
* The interest on Treasury bonds and agency bonds is taxable for federal income tax purposes, but not state and city income taxes.
* The interest on inflation-protection bonds is also subject to federal tax but is deferred until maturity.
* Municipal bonds are tax-exempt.
Joan purchased a municipal zero coupon bond for the state that she lives in and holds it to maturity. Which of the following taxes will apply to her?
* Federal income tax
* Not subject to taxes
* State income tax
* Phantom interest tax through accretion
* Capital gains tax
Not subject to taxes
* Municipal zero coupon bonds are not subject to any taxes if held to maturity.
* If Joan had bought a U.S Treasury zero coupon bond, then she would have had to declare the discount annually through accretion as income.
What type of bonds have their redemption value adjusted semi-annually?
* Treasury bonds
* Agency bonds
* Municipal bonds
* Zero-coupon bonds
* Inflation-protection bonds
Inflation-protection bonds
* The redemption values of inflation-protection bonds are adjusted semi-annually to reflect the rate of inflation in the previous six months.
Section 2 – Taxation of Stocks
As with most investments, the dividends and capital gains of stocks held outside of a tax-advantaged account are taxed. Dividends are profits of the company that the board of directors declares and pays out to shareholders. Capital gains are made when the shareholder sells the stock for more money than what he or she paid for the shares.
To ensure that you have a solid understanding of the tax considerations for stocks, the following topics will be covered in this lesson:
* Dividends
* Basis Determination
* Capital Gains and Losses
* Liquidations
* Stock Splits and Dividends
* Warrants and Rights
Upon completion of this lesson, you should be able to:
* State the tax treatment of dividends,
* List and describe the methods for determining the cost basis of stocks,
* Explain the taxation of capital gains and losses,
* Specify the tax consequences of liquidation on the shareholders,
* Describe the effect of stock splits and stock dividends on cost basis, and
* Define stock rights.
Dividends are not subject to taxation if they are reinvested to purchase more shares.
* False
* True
False.
* Even when dividends are not paid out in cash they are taxed as ordinary income.
Describe the First-in, first-out (FIFO) method for cost basis
First-in, first-out (FIFO) method uses the first shares purchased as the cost basis. This method is effective if the first shares purchased were the most expensive.
The cost of shares is used in the order purchased for determining cost basis according to FIFO method. The oldest shares owed are considered to be the ones that are sold first. This method is the default method that the IRS will assume a taxpayer is following unless otherwise specified in a statement attached to the income tax return.
For example, Janet buys the following round lots of StreamVid, Inc.:
* 200 shares on January 3, 2009 at $1.50/share
* 300 shares on September 5, 2012 at $10.50/share
* 200 shares on April 20, 2022 at $9.50/share
On September 15, 2022 she sold 400 shares at $10/share. What is her cost basis according to the FIFO method?
According to FIFO, she would exhaust the basis of the shares purchased the earliest first:
200 shares at $1.50
200 shares at $10.50
Therefore, the gain/loss for this sale was:
200 shares ($10 - $1.50) = $1,700
200 shares ($10 - $10.50) = -$100
Net gain for the sale = $1,600.
Since all 400 shares were held over a year, the $1,600 gain would be subject to long-term capital gains taxes.
PRACTITIONER ADVICE:
In the ideal world where an investment increases in value, this would be the least efficient method of determining cost basis. If an investment’s value rises over time, then the shares purchased the earliest cost less and would produce the greatest taxable gain.
Describe Specific Share Identification
The specific share identification implies that specific shares are used to apply against the shares sold.
Before selling shares, the shareholder must instruct the broker or fund company regarding which shares are to be sold. These instructions must be given at the time of sale or transfer, not later. The broker or agent must confirm this request within a reasonable time after the sale.
This method can be used effectively only if the shareholder has kept accurate records and has followed through on the receipt of confirmations from the broker. It allows the shareholder to control the capital gains taxes that he or she has to pay because this can be determined by selecting the shares to sell. Long term or short term gains can also be controlled. This is the preferred tax basis method for investors who actively manage their portfolio for tax efficiency.
PRACTITIONER ADVICE:
This method is the best method for tax purposes because the investor has absolute control over how much the gain from a sale would be. It is also not the most cost effective because of all of the effort that is required for proper record-keeping.
Which of the round lots should Janet identify first to offset the sale of 400 shares at a $10/share?
* 300 shares at $10.50/share
* 200 shares at $1.50/share
* 200 shares at $9.50/share
300 shares at $10.50/share
* The shares that provides the greatest capital loss or the least capital gains should be the ones identified to be sold first. Therefore the lot with $10.50/share would be sold first because the lot can provide a $0.50-loss per share. The $9.50/share lot would be next to be sold in order to offset the remaining 100 shares because it only provides $.50 gain rather than the $8.50 gain from the $1.50/share lot.
Section 2 – Taxation of Stocks Summary
Shareholders receive distributions in different forms from the companies in which they hold stock. Distributions may be in the form of cash dividends or stock dividends, which are subject to taxation. Several other events may also cause taxation, such as realizing capital gains or losses through the sale of the stock, liquidation, stock splits, and acquisition and sale of stock rights and warrants.
In this lesson, we have covered the following:
* Dividends are subject to federal taxes and any applicable state and local income taxes.
* Basis Determination is important for calculating the amount of gains. The cost basis of stock is the amount the shareholder has actually spent on the stock. There are three methods of determining cost basis, which are FIFO, average cost method, and specific share identification.
- Capital Gains and Losses are incurred when a stock is sold. Short-term capital gains are taxed as regular income while long-term capital gains are taxed at a lower rate.
- Liquidations result in capital gain or loss for the shareholder that is equal to the difference between the liquated amount and the adjusted basis of the shareholder’s stock.
- Stock Splits/Dividends are not taxable events but the shareholder must keep a record of them because they affect cost basis and the records may be required for filing of income tax returns. Some stock dividends are subject to taxes, but they are rarely declared.
- Warrants and Rights may result in gain or loss for the stockholder. The stockholder is taxed on the capital gain or loss in relation to the cost basis. If exercised, the basis of the stocks received will begin on the day that the warrant or right was exercised.
If a person received stock as an inheritance, the starting basis is the value of the stock:
* On the date the original owner purchased it plus any cost of purchase such as commissions.
* On the date the original owner died.
* Nine months from the date the original owner died.
* When the original owner purchased it.
On the date the original owner died.
* If the person received the stock as an inheritance, the starting basis is the value of the stock on the date the original owner died. This is called a stepped-up basis.
