Investors hold stocks and bonds to ensure diversification of their portfolios. But the investment instruments share one feature: Taxes must be taken into account.
Profits on stocks that are held for more than a year are known as long-term capital gains, and they are taxed at a lower rate than what is owed on ordinary income. The current long-term capital gains tax rate is 15 percent for individuals in the 25 percent income tax bracket or higher.
Shareholders in the 10 percent or 15 percent income tax brackets get an even better tax deal. They owe no tax on long-term capital gains.
Short-term capital gains are the profit on investments held for a year or less. This money is taxed at ordinary income tax rates, which currently top out at 35 percent.
Certain dividend payments receive the same preferable tax treatment as long-term capital gains. Known as qualified dividends, brokers delineate which dividend payments meet the tax standards and list the qualified and ordinary dividend amounts, which are taxed at the higher ordinary income tax rates, on annual 1099 statements issued to investors.
Don’t forget state taxes on investment income. Many states don’t have separate capital gains tax rates and instead tax capital gains at ordinary state income tax rates.
New federal tax rates on the horizon
The 15 percent and zero percent tax rates for capital gains and qualified dividends are scheduled to expire Dec. 31, 2012. If Congress makes no changes by then, beginning in 2013 the long-term capital gains tax will be 20 percent for higher-income investors and 10 percent for investors in the two lower tax brackets.
Also beginning in 2013, higher-income investors will face a new Medicare tax. Currently, the Medicare tax is 2.9 percent on wages, paid equally by employees and employers, and there is no limit on the income subject to the tax.
The new Medicare tax will be 3.8 percent of net investment income, which includes interest, dividends, capital gains, annuities, royalties, rents and pass-through income from passive business activities.
It will apply to married couples filing jointly and surviving spouses who have a modified adjusted gross income of $250,000 ($125,000 if married filing separately) or more and single and head of household taxpayers earning $200,000 or more.
Most investors buy bonds for their relative safety and as an income-producing component of their portfolio. Bonds come in many varieties, with just as many tax treatments.
Some common types of bonds and their tax considerations include:
- U.S. Treasury bills and bonds, issued by the federal government and which generate income that is taxed by the Internal Revenue Service. There are, however, no state or local income tax concerns.
- Municipal bonds are issued by various cities throughout the United States. They are tax-free on the federal level. If you buy muni bonds issued by the state where you live, you don’t have to pay state or local taxes on them either.
- Corporate bonds are debt instruments issued by companies to raise capital. They are fully taxable at federal, state and local levels. Capital gains on a corporate bond also might be incurred if the bond is sold at a profit before it matures.
Uncle Sam also issues two other popular types of bonds, zero-coupon bonds and savings bonds.
Zero-coupon bonds are sold at a deep discount and their full face value and interest earned each year are paid at maturity. The bond holder, however, is liable for federal, state and local income tax on the “phantom” annual interest that accrues even though the owner doesn’t receive it until the bond matures.
Savings bonds are free from state and local taxation. Federal taxes on Series E and EE savings bond interest are deferred until the bonds mature. Such deferral also is available for Series I bonds. Moreover, interest on Series E, EE and I bonds can be excluded from income if the bonds are used to pay higher-education expenses.
Series H and HH savings bonds pay taxable interest semiannually until maturity.