Investing 101 - Taxes and Investing

<p><p>It is often said only two things in life are certain: death and taxes. Next to coming up with a proper asset allocation, taxes are probably the most important factor that will determine your long-term investing success. As you will see, when and how you pay taxes can have a dramatic impact on your long-term returns.</p> <p><strong>Investment Taxes 101</strong></p> <p>When you buy an asset, be it a stock, bond, piece of real estate, etc and sell it for more than you paid, you have generated what the IRS calls "taxable income." The tax rate owed on this gain depends on several factors.</p> <p> If you sold the asset for a gain less than one year from the time you bought it, it is considered a short-term capital gain by the IRS and is taxed as regular income, just like income from your job. Currently, the highest marginal tax rate for regular income is 35%, although this is of course subject to change at the whim of Congress.</p> <p>If you hold an asset for longer than one year after buying it, your gain is considered a long-term capital gain. Long-term capital gains are taxed at a lower rate than short-term capital gains in order to encourage long-term investment. This favorable tax treatment makes sense if you think about it: long-term investment is much more likely to create new jobs and fund the discovery of new technologies than is short-term investment. Currently, long-term capital gains are taxed at a maximum rate of 15% (although President Obama has expressed interest in raising the rate to 20% or even more).</p> <p>Bond interest and stock dividends have their own tax treatment. Bond payments are simply taxed as regular income at your regular marginal tax rate (excepting municipal bonds, which are a special case). Qualified stock dividends, on the other hand, are currently taxed at the same rate as long-term capital gains, or 15% for most investors. The reasoning behind this is that since shareholders are the actual legal owners of the company, they have already paid taxes on their earnings once in the form of the corporate tax. The separate tax on dividends is widely seen as a double tax, and so the dividend tax was lowered by President Bush in order to avoid the problem of double taxation of corporate earnings.</p> <p>The above tax treatment applies only to taxable investment accounts, of course. Investments held within tax-advantaged retirement accounts such as IRAs and 401ks have entirely different tax characteristics.</p></p>

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