Question on how investments are taxed

[Whiskers]

This might seem obvious to many of you, but having just filed my annual taxes, I've realized that I don't fully understand how non-tax advantaged investment accounts are taxed. For instance, i get that if you buy a stock or a mutual fund and hold it for more than a year, you are taxed at a lower "capital gains" rate and if you sell prior to a year your earnings are subject to regular rates, but what does this mean practically? Are taxes harvested every year on long-term investments even if you don't sell them? And if so, is the basis adjusted going into the following year? Or, are you only subject to tax when the investment is actually sold? What if it is a managed mutual fund with dividends? What happens if profits are automatically reinvested? ...... and the all-important FiIRE-related question: what happens when you start pulling out the cash to live on?

Thank you in advance for any clarifications. Also, if there is another thread on point or article that you can refer me too, that would be appreciated.

[Frankies Girl]

I am by no means an expert, but I can try to hit the major highlights as I understand them.

Just discussing taxable brokerage accounts... and assuming you're in the U.S.

First and foremost, you pay zero taxes on any dividends/cap gains if your taxable income bracket is 15% or less. So for 2017 (according to the chart I just googled) single filer upper limit is $37,950 and a married filing jointly is $75,900. As long as your total taxable income (which includes savings account interest, working income, dividend/cap gains, unemployment...etc.) falls under those limits (depending on your single/married status), you won't pay anything towards taxable account moves. And if you're really near the income cut offs and a distribution or cap gain pushes you up into a higher bracket, at least you'll only pay tax on the amount over those limits, so it's not like it will be a terribly costly amount owed.

Reinvestments just mean you're creating new tax lots of the fund however often it reinvests. So if you do decide to sell, checking to make sure the amount you want to sell off includes only long term (over 1 year's time) of funds is a good idea. I have my taxable account set to not reinvest automatically because I use the cash for living expenses (and it counts towards my taxable income anyway so might as well use it). But if you are still building your investments, it is generally a good idea to reinvest automatically. Fortunately, most companies now automatically track the funds' investment dates and cost basis for you so you can see pretty easily what amount of funds is in the long term and short term.

If you don't sell off anything, then you don't realize capital gains. BUT some funds do distribute dividends (twice a year seems to be average - small distribution in spring and larger one in December) so be aware of funds doing this and either minimize holding funds that do so, or make sure to figure into your taxable income. Avoid buying funds right before a distribution because you're going to be assessed that distribution and may owe taxes on it (which would suck if you JUST bought a bunch).

Short term capital gains are taxed higher than long term cap gains. Hold a fund at least one year before selling it, and it becomes a long term. Simple way to avoid a higher tax hit.

Good place to start:

https://www.bogleheads.org/wiki/Tax_basics
https://www.bogleheads.org/wiki/Capital_gains_distribution
https://www.bogleheads.org/wiki/Dividend

[Whiskers]

Thanks for the explanation.

It sounds like capital gains are not taxable until an investment is actually sold or until a dividend is issued, then? So if I buy an index fund or a stock and just hold it for 10 years, I am not taxed on anything during that 10 year period other than the dividends that are disbursed?

[maizefolk]

Yup. That's one of the argument for why companies have shifted towards trying to produce more capital gains instead of distributing more of their profits each year as dividends. (The dividends get taxed each year as they are distributed, the capital gains compound indefinitely tax free until you actually sell the underlying securities.)

[mathjak107]

Thanks for the explanation.

It sounds like capital gains are not taxable until an investment is actually sold or until a dividend is issued, then? So if I buy an index fund or a stock and just hold it for 10 years, I am not taxed on anything during that 10 year period other than the dividends that are disbursed?

not true .

all index funds have turnover . many do not hold all the stocks in the index and jump around trying to capture the market without owning it . there is  also turnover as some things get bumped out .

some funds are worse than others . here are some s&p index funds  and as you see the effective tax expense from turnover can be a lot in some funds .

as little as a 1% distribution in dividends can wipe out any advantage of the 15 or 20% special capital gains rates over the long term .

[mathjak107]

Yup. That's one of the argument for why companies have shifted towards trying to produce more capital gains instead of distributing more of their profits each year as dividends. (The dividends get taxed each year as they are distributed, the capital gains compound indefinitely tax free until you actually sell the underlying securities.)

keep in mind you get taxed on the entire amount of the dividend , if you create your own dividend by selling off equal dollars only the gains are taxed not the total amount

[SeattleCPA]

Agree with MathJak's math, but I would also point out that most people and most retirees pay pretty modest federal income taxes on their long-term capital gains and qualified dividends income.

Earlier this week I did a blog post that described an easier way to think about income tax rate brackets, deductions and personal exemptions is as if they're "buckets" you pour income into:

http://evergreensmallbusiness.com/income-tax-buckets-not-income-tax-brackets/

In that post, I describe the common scenario where someone with modest ordinary income but significant LT capital gains and qualified dividends pays zero income taxes because deductions and exemptions shelter their ordinary income and that leaves the entire 10% and 15% tax rate brackets for LT cap gains and qualified dividends (which means the taxpayer pays zero income taxes on that investment income.)

BTW, we pretty regularly see someone with, e.g., $5M of taxable investments earning six figures of investment income paying zero or nearly zero income taxes.

[NorthernBlitz]

We didn't have a taxable account in 2016, but may have one in 2017.

If you are under the 15% limits, should you sell taxable investments such that the profit in them gets you to the limit? Then the buy back in to the same fund.

It seems like doing this wouldn't increase current taxes, but would decrease future taxes.

Is this a legitimate thing to do?

[SeattleCPA]

We didn't have a taxable account in 2016, but may have one in 2017.

If you are under the 15% limits, should you sell taxable investments such that the profit in them gets you to the limit? Then the buy back in to the same fund.

It seems like doing this wouldn't increase current taxes, but would decrease future taxes.

Is this a legitimate thing to do?

I guess that's technically true... but it seems like too much work. Also, you're probably even less likely to pay taxes in the future...

And then this thought, too: Vanguard, for one example, is not necessarily going to let you sell some fund on Monday and then repurchase it on Tuesday. That trading jacks costs for the fund. So they have prohibitions against doing that. They may make you wait a month. That isn't what...

[Errol Flynn]

We didn't have a taxable account in 2016, but may have one in 2017.

If you are under the 15% limits, should you sell taxable investments such that the profit in them gets you to the limit? Then the buy back in to the same fund.

It seems like doing this wouldn't increase current taxes, but would decrease future taxes.

Is this a legitimate thing to do?

Something to consider: although you won't be hit with a federal income tax if you're in the 15% bracket, most states treat capital gains as ordinary income, so you may be increasing your state taxes depending on where you live. That being said, the process you describe (referred to as Tax Gain Harvesting) is legitimate and generally a good move if you're in the bottom two tax brackets and especially if you expect to be in higher brackets in the future. The Mad Fientist has a great article about it: http://www.madfientist.com/tax-gain-harvesting/

[NorthernBlitz]

Thanks SeattleCPA & Errol Flynn

Seattle: Sitting out a month sounds like too steep a cost. I think I remember hearing that having money out of the market on the top 3-5 trading days can have a very detrimental effect on portfolio performance.

Errol: I had heard about Tax Loss Harvesting, but not Gain Harvesting. I never really got into it too much since we don't have a taxable investment account. I will check out the article at MF.

[SeattleCPA]

Seattle: Sitting out a month sounds like too steep a cost. I think I remember hearing that having money out of the market on the top 3-5 trading days can have a very detrimental effect on portfolio performance.

Yeah, I agree. Seems too complicated and unnecessarily risky for a potentially small benefit.

[jim555]

Don't forget you need to hold a security for a certain number of days (depending on type of security) for the dividend to be classified as qualified.

[Systems101]

some funds are worse than others . here are some s&p index funds  and as you see the effective tax expense from turnover can be a lot in some funds .

[snip]

...and this is an advantage of ETFs over Mutual Funds.  The ETF is MUCH less likely to spin out capital gains.  Rather, it will only send out dividends... See: http://www.thinkadvisor.com/2015/03/02/under-the-hood-tax-treatment-of-etfs-vs-mutual-fun

[mathjak107]

yes etf's do spin off less distributions but they can still have some . they do a lot of arbitraging to keep them consistent with the underlying assets  but not everything can be traded for like kind