Chapter 6: Tax Considerations
Regressive Tax System
A progressive tax system stands in contrast to a regressive tax system, where individuals are taxed uniformly at each income level. Proponents of this approach often call it a "flat tax," which it is. Opponents like to call it unfair, since someone earning $50,000 per year would pay the same tax rate (or percentage of taxable income) as someone earning $1 million per year.
What type of tax system is America under?
Americans are taxed under a progressive tax system, meaning that non-investment income is divided into brackets that are taxed at increasingly higher rates as an individual earns more money.
An investor paid $20 per share for 100 shares of XYZ and a $40 commission. What is the investor's cost-basis per share?
Answer: $20.40 Explanation: The $40 commission on a per share basis is $.40 so $2,040 / 100 shares = $20.40 per share. If the investor now sold all 100 shares at $25 for $2,500 with a $40 commission, the proceeds would be $2,500 - $40 commission = $2,460 net. Divided by 100 shares, the net proceeds per share would be $24.60. Therefore, the capital gain per share would be $24.60 - $20.40 = $4.20 per share, or $420 total for the 100 shares.
An investor wanting to reduce possible exposure to the AMT tax might consider all of the following strategies except: A. Contributing the maximum to a 401(k) plan B. Investing in private activity municipal bonds C. Offsetting capital gains with capital losses D. Living in a low-tax state and never having children or any other dependents
Answer: B Explanation: Anything that reduces your adjusted gross income (AGI) reduces potential exposure to the alternative minimum tax. Thus maximizing contributions to an employer-sponsored retirement plan, such as a 401(k) plan, is a smart move. Likewise, offsetting capital gains with capital losses will keep your AGI down and, thus, reduce AMT exposure. Since the AMT hits taxpayers in high-tax locales the hardest (under the AMT, state and local income and property taxes are not deductible), living in a low-tax state could minimize your AMT exposure, as would not having children, since without them, you would not lose the dependent deductions under the AMT calculation. However, investing in private activity municipal bonds would increase potential AMT tax, since unlike most municipal bonds, interest from private activity bonds is not tax-free under the AMT.
Realized Capital Gains vs. Unrealized Capital Gains
Appreciation in value on a security is not taxed until the security is actually sold. Before the security is sold, any appreciation is referred to as an unrealized capital gain. When the security is sold, it is referred to as a realized capital gain, and all realized capital gains are taxed. For the exam, remember that the taxes on unrealized gains will be $0.
How is investment income broken down from a tax point of view?
But from a tax point of view, investment income consists primarily of two things 1) dividends 2) interest paid to investors on their investments.
Are capital gains taxed more or less than investment earnings?
Capital gains are a very favorable form of investment earnings and are taxed at a lower rate than ordinary earned income (wages, business income, etc.). In fact, for some investors, they pay nearly twice as high a tax rate on their ordinary income bucket as they do on their capital gains bucket.
What types of investment income are exempted from being placed in any of the tax buckets?
Certain types of investment income are exempted from being placed in any of these buckets and have their own special buckets with special rates. These include the capital gains, interest, and dividend income discussed in this chapter.
Susan, a resident of Mississippi, has purchased a Georgia municipal bond with a rate of 5.12%. If Susan's federal tax bracket is 30% and the state income tax rate is 4%, what would she need to earn on a corporate bond to have a comparable rate?
Corporate bonds are taxed at the federal and state level. Municipal bonds are not taxed at the federal level, but in this case, it will be taxed at the state level, because Susan is not a resident of Georgia. Thus, to get the comparable corporate rate, we need to divide by 1 minus Susan's federal rate.
How is dividend income taxed?
Dividend income, or the portion of a company's profits that the company pays out to its stockholders, is given special tax treatment. While not all stocks pay dividends, those that do are either taxed at ordinary income tax rates or at a special rate for "qualified" dividends. To be considered a qualified dividend, it must come from a U.S. company that an investor has held more than 60 days prior to the date the stock's dividend is paid. Currently, that rate ranges from 0% to 20%, as opposed to much higher ordinary income tax rates. This rate is the same rate as the capital gains rate for the individual. Occasionally, a company will pay out a stock dividend rather than a cash dividend. Investors are not taxed on stock dividends as they are on cash dividends.
How do you record the tax basis associated with commissions and fees?
For example, if someone buys a share of ABC Company for $100 plus a $10 commission, the tax basis of that stock against which taxable profits will be measured is $110 ($100 for stock + $10 for commission). In this instance, the tax basis that will be reported on an investor's tax return is the combined total of the price of the stock and the commission. However, when an investor sells the stock, the commission is treated differently when computing the tax basis. Instead of adding the commission for selling the stock to the original cost basis, it is instead subtracted from the reported proceeds, or money received from the sale. So, if a client's same ABC Company stock later sells for $135 and the client pays a $10 commission to sell it, she would actually report proceeds of only $125 ($135 for the stock, minus $10 commission).
Jon sells 300 shares of XYZ. He has realized a loss of $1,200 on the shares. Two weeks later, he has a change of heart and buys them all back at $20 per share. He may not use the loss on this year's annual tax return, but he may apply the $1,200 to the cost basis of the new shares. What is his new cost basis?
His new cost basis for the new shares is $24 per share.
How is capital gains taxed on the sale of mutual fund shares?
If an investor sells or exchanges mutual fund shares for a profit, she has to pay a tax on the gain. If she holds the shares for one year or less, she will pay at the short-term capital gains rate, which is her ordinary income rate. If she has held the shares for more than one year, she must pay the long-term capital gains rate. Investors are required to pay capital gains taxes when they sell shares of tax-exempt funds (for example, municipal bond funds) at a profit. When an investor exchanges shares in one fund for shares in another fund of the same family (using the conversion privilege), the investor is required to pay taxes on any gains.
How are short-term capital gains taxed vs. long-term capital gains?
If the client held the security for one year or less, the IRS will consider the gain/loss to be short-term, and if the client held the security for over one year, the IRS will consider the gain/loss to be long-term. Short-term gains are taxed at the taxpayer's ordinary rate, while long-term gains are taxed at a lower rate (0% to 20%). According to the IRS, the holding period clock begins the day after the investment was purchased and ends on the day the investment was sold. The date of purchase and sale are the trade dates rather than the settlement dates. If an investor bought a security on January 5, 2014, and sold it on January 5, 2015, it would be considered a short-term gain/loss. On the other hand, if the investor bought the security on January 5, 2014, and sold it on January 6, 2015, it would be considered a long-term gain/loss.
Progressive Tax System
If the first two buckets (they are actually called tax brackets) can't hold all the earned income a taxpayer has for the current year, then the remainder flows over to the next highest tax rate bucket, and so on. Each bucket has a tax rate that is higher than the previous bucket so the people making the least pay the lowest tax rate and the people making the most pay the highest tax rate—this is the core idea in our progressive system.
Tax Basis
In determining what profit an investor must include on their tax return, the IRS requires them to first calculate their tax basis (also known as cost basis) on the investment. The tax basis is the starting value (the price you paid) that an investment's profit or loss must be measured against, as adjusted for things like commissions, stock splits, etc., which can raise or lower the tax basis. For example, if someone buys a share of ABC Company for $100 plus a $10 commission, the tax basis of that stock against which taxable profits will be measured is $110 ($100 for stock + $10 for commission).
Stepped-Up Tax Basis on Inherited Securities
In the event that a taxpayer dies and his heirs inherit his securities positions, the tax laws give the new owners of the securities a huge break. No matter what the original owner paid for the securities, the people inheriting the securities get to claim the price of those securities on the deceased person's date of death as the securities' new tax basis. This is referred to as a stepped-up basis. For example, if a rich uncle leaves one of your clients 10,000 shares that he bought at a penny a share, your client's tax basis is not the uncle's original price of one penny per share (which would result in huge capital gains taxes when sold). Your client's tax basis is actually the price of the stock on the day the uncle died. If the stock was trading at $100 a share on the day the uncle died, that is your client's starting point for calculating profit or loss, not the penny a share the uncle paid for it. In addition, even if your client immediately sold the stock, any profit would be considered a long-term gain.
How are dividend reinvestment plans taxed?
Many individual stocks and most mutual funds offer plans that automatically reinvest dividends and interest earned into the purchase of additional securities issued by the same company. When an investor participates in such a dividend reinvestment plan, or DRIP, they are taxed on the amount of the dividends paid, even though the dividends are immediately being reinvested. The tax basis for the reinvested dividends (new shares purchased) is the share price on the day the new shares were purchased. The original shares retain their original tax basis when participating in a dividend or interest reinvestment plan, and the investor begins acquiring new shares at new prices. When the shares are sold, the investor is required to recalculate the individual gain or loss on each position.
What are the tax benefits of treasury and municipal securities?
One reason why an investor may choose to purchase Treasury or municipal bonds is that her interest is taxed at a lower rate than corporate bonds. For Treasury bond interest, an investor pays federal taxes, but no state taxes on earnings. For municipal bonds, the tax benefits can be even greater. Investors pay no federal taxes on earnings from municipal bonds, and also pay no state or municipal taxes if they live in the state or municipality that issued the bond. For this reason, sometimes municipal bonds are called "triple tax-free bonds."
What are the different filing statuses?
Single - Single individuals are unmarried taxpayers with no dependents (individuals who financially rely on them for 50% or more of their support) that are reporting only their own personal income on their tax return. Head of HH - Unmarried individuals who are reporting only their income but financially support one or more dependents have head of household filing status and have slightly larger buckets. Married Filing Jointly - Married individuals filing under the married filing jointly status (regardless of whether they have dependents) have the largest buckets. Married Filing Seperately - Occasionally, married individuals will file as married filing separately, which simply halves the size of the buckets and other deductions, limits, etc.
Taxable Deductions and Exemptions
Taxpayers are allowed to take a number of deductions and exemptions from their income that reduce the amounts that they're taxed on. These deductions can range from things like deductions for charitable donations to the deduction they may receive for placing money in an individual retirement account.
Alternative Minimum Tax (AMT)
The alternative minimum tax, or AMT, is an alternative way of calculating income taxes. It was created as a backstop to make sure wealthy taxpayers could not avoid paying any income tax at all. The AMT is often called a "parallel" tax system since it is not truly an alternative, optional way of calculating your income taxes. Instead, taxpayers are required to calculate their alternative minimum taxable income (AMTI) and pay the tax on this amount if it is greater than what they owe under the regular income tax calculation. However, most Americans do not have to worry about paying the AMT, since it primarily hits higher income taxpayers. For the very highest earners, however, the AMT is less of an issue, since the top marginal federal income tax rate is higher than the maximum AMT rate. This means the mega-rich usually pay a higher tax bill with the regular tax calculation than via the AMT method.
What is a good metaphor for a progressive tax system?
The best way to understand the concept of a progressive tax system is to imagine that the government allows you to fill up a series of imaginary buckets with a portion of your earned income (wages, earnings from your business, rental properties, etc.), with each bucket being taxed at a different rate. Everything you can fit into the first bucket is taxed at the lowest income tax rate. If you have more earned income than can fit into that first bucket, what is left overflows to the next bucket, which is then taxed at a higher rate. This does not mean the first bucket is then taxed at a higher rate ... only the additional money that overflows to that next bucket.
How do you compare the after-tax yield of corporate bonds to treasury/municipal bonds?
The most straightforward way is to multiply the yield of each kind of bond by one minus the tax rate for the bond. For example, imagine an investor who has a federal tax rate of 27% and a state tax rate of 3%. The investor would like to compare a corporate bond with a 10% yield and a municipal bond issued by the state in which he lives that has a yield of 7.5%. We can calculate the corporate bond's after-tax yield by multiplying 10% x (1 - 0.30), which equals 7%. We can compare this after-tax yield directly to the yield of the municipal bond, because the investor will not pay federal or state taxes on this municipal bond. In this case, we see that the municipal bond, with a tax-free 7.5% yield, beats the corporate bond's after-tax yield of 7%. after-tax yield on a corporate bond = coupon rate x (1 - tax rate) Another approach to this question is to calculate the tax-equivalent yield (TEY) of the municipal bond. This is also called the corporate equivalent yield (CEY). This concept measures the yield that a corporate bond will have to pay to be equivalent to a municipal or Treasury bond, factoring in the investor's tax rate. Again, consider the investor with a 27% federal tax rate and a 3% state tax rate. If the investor is considering a municipal bond issued by the investor's own state, the investor will not pay federal or state taxes on this bond. We can calculate the corporate equivalent rate by dividing the municipal bond yield by one minus the investor's tax rate. In this case, 7.5% / (1 - 0.3) = 10.7%. Thus, the investor would have to invest in a corporate bond with a yield of at least 10.7% to match the municipal bond's yield.
Filing Status
The size of the bucket is affected by what is known as someone's filing status, which is how a person files. i.e. single, head of household, married filing jointly, etc.
Capital Gains
The tax term for a profit made by selling an investment is a capital gain. The term comes from the fact that-the-money you put into the investment, or capital, experienced an increase (gain) in its value compared to its purchase price.
How is interest income taxed?
The taxation of interest income, which is essentially "rent" paid to an investor for the use of his money, is pretty straightforward. All interest received is added up for the calendar year, any interest paid by the investor in the process of investing is subtracted from that, and the bottom line number is reported on an investor's tax return as interest income. With two primary exceptions, the interest earned by an investor throughout the year is taxed as ordinary income (just like someone's wages).
What are the biggest differences between individual income taxes and corporate taxes?
The two biggest differences between individual income taxes and corporate taxes are in the 1) rates that corporations pay and the 2) deductions they are and are not allowed. With regard to the income tax rates, there are many more income tax brackets for individuals than there are for corporations. Individual tax rates start off relatively low and climb at a moderate pace as taxpayers earn more money. Corporate tax rates, on the other hand, start at a relatively high rate compared to individuals and have only a couple of primary brackets. When it comes to deductions, corporations are allowed to take certain deductions and receive certain tax credits that individuals are not entitled to, such as credits for research and development and domestic manufacturing credits.
What are the two notable exceptions to interest income taxation?
The two notable exceptions are tax-free municipal bonds, which may pay interest that is not taxed by either the state or federal government (or both), and U.S. Treasury bonds, which are not taxed at a state level for most investors. This will be discussed further in the following section.
Catie, a resident of Georgia, has purchased a Georgia municipal bond with a rate of 5.12%. If Catie's federal tax bracket is 30% and the state income tax rate is 4%, what would she need to earn on a corporate bond to have a comparable rate?
This municipal bond will not be taxed at either the federal or state level, because Catie is a Georgia resident. To get the comparable corporate rate, we need to divide by 1 minus the federal plus the state tax rate.
What investment choices would help higher income taxpayers avoid AMT exposure?
Were the exam to ask you to select which investment choice would help a higher income taxpayer avoid AMT exposure, you would want to pick anything that lowers adjusted gross income (AGI), because the lower your AGI, the lower your AMT. Contributions to employer-sponsored retirement plans such as 401(k), 457, 403(b), and SIMPLE IRA plans, as well as a traditional, deductible IRA, and health savings accounts, all reduce AGI and, thus, reduce potential AMT tax.
Tax Basis on Gifted Securities
When a living person gives a security to another person as a gift, the recipient's cost basis is the lower of the (1) giver's cost basis or the (2) fair market value at the time of the gift. The giver's holding period will correspond to cost basis. For example, if the giver has held the security for two years with a cost basis of $20, and the security is now worth $30, the recipient's cost basis would also be $20 with a holding period of two years.
Wash Sales
While losses can almost always be used to offset gains, there is a limitation. When an investor sells securities at a loss and then buys back the same or substantially identical securities within 30 days, the investor cannot use the loss to offset gains. This is considered a wash sale, according to IRS rules. Moreover, the investor could not have purchased replacement securities 30 days before the sale either—this would also be considered a wash sale, because the investor is replacing the shares that they are selling at a loss. Thus, the wash sale period is 30 days before the trade and 30 days after the trade, plus the day of the trade.
How are mutual funds taxed?
• Interest on bonds is taxed at the investor's ordinary income rate. • Dividends are taxed at either the qualified rate or the investor's ordinary income rate, depending on the dividend. • Capital gains distributions are taxed at the short-term capital gains rate if the fund held the security one year or less. The short-term capital gains rate is the investor's ordinary tax rate. • Capital gains distributions are taxed at the long-term capital gains rate if the fund held the securities for more than one year.
