Around this time of year, brokerage firms begin issuing 1099s to individuals and businesses who have investment income to report to the IRS. Having been on the tax side of the business, I’ve spent many hours reading over 1099s and plugging those numbers into tax returns (I promise I didn’t just do this for fun). However, to the retail consumer, 1099s can be extremely complicated to understand and how exactly they affect the result of a tax return.
Focusing on non-qualified accounts (in other words, taxable, non-IRA accounts), anytime a security (stock, mutual fund, ETF) is purchased, how much you spent to purchase that security is known as your cost basis. If you purchase one share of stock for $50 per share, your cost basis is $50. Let’s say a month later, the stock goes up in value to $60 per share. At this point in time, there is no effect on your tax return. Essentially, you’ve made $10 by purchasing that stock. You only pay taxes on the money you make once you sell the security. So, were you to sell the security at $60 per share, you’d owe taxes on the realized gain, which is the amount you sold it for less the cost basis ($60-$50=$10). On your tax return for the year in which you sold the security, you’d have a $10 realized gain show up.
Realized gains are classified as either long term or short term. A short term gain is when you hold a security for less than one year. You pay taxes on the gain at your marginal tax rate, so just like ordinary income. A long term gain is when you hold a security for longer than one year. You pay taxes on the gain at a lower, more favorable tax rate.
Dividends are issued from companies to shareholders by way of returning excess profit. So, regardless of how the individual stocks or fund performs in a year, the company can still issue a dividend. Qualifying dividends are taxed at capital gains tax rates. Regardless of a stock or fund’s performance, dividends can still be issued and result in tax being owed to the IRS.
Mutual funds are known for issuing pretty large capital gain distributions in recent years. Essentially, the managers of these funds buy and sell individual stocks and securities inside these funds and pass the gains on to the investors of the mutual fund. So, these short and long term capital gains end up showing up on your tax return. Even if the value of the fund is negative for the year, there is still likely transactions inside of the fund occurring that will end up resulting in capital gains issued to the mutual fund shareholder.
Some wise words I once heard about taxes were, “If you’re paying taxes, you’re making money.” Meaning, if your tax bill continues to go up, that just means you’re making more money, which is a good thing. A saying David likes to say around here is “Don’t let the tax tail wag the investment dog.” Minimizing taxes is important, but it shouldn’t drive 100% of your investment decisions. However, it’s extremely critical to be as tax efficient as possible when it comes to investments in a taxable account. This brings on an entirely different discussion around individual stocks versus ETFs versus mutual funds and how they affect the bottom line of investment performance. We’ll save that discussion for our next article. Stay tuned!
Any opinions are those of the author, and not necessarily those of Raymond James. This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Investments mentioned may not be suitable for all investors. Raymond James does not provide tax or legal services. Please discuss these matters with the appropriate professional.