People try to live within their income so they can afford to pay taxes to a government that can’t live within its income.
In last week’s stock investment post, I went over several measures of corporate health such as the EPS, P/E and beta. All these parameters were explained because they help you achieve a better return on investment (ROI). However, what I did not discuss was the effect of taxation on your ROI. Taxation is critical because the IRS can take a huge bite out of your hard-won investment gains. This is especially true if you are wheeling and dealing as a day-trader. Simply put, you must evaluate your stock trade not only in terms of its profitability but also in terms of how that profitability will be reported on your income tax return.
The difference between long and short
When investors talk about being long on a particular stock, they are usually referring to buying and holding it for a year or more. This strategy has several advantages including a lower capital gains tax rate. For stocks held one year or longer, the current long-term capital gains tax is as follows:
0% (yes, zero!) if your total income (including long-term capital gains) places you in the 10% or 15% tax brackets.
15% if your total income places you in the 25% or higher tax bracket.
However, short-term capital gains taxes are different:
10% – 35% depending on your income tax bracket.
15% – 39.6% if we revert to pre-2001 tax brackets starting in 2013.
The difference between 15% and as much as 35% or 39.6% is huge. To better illustrate this difference, consider if you had bought 3,000 shares of a stock that started at a price of $18.10 and ended at $19.23 by the time you sold it at the end of 10 months. This strategy would’ve resulted in $3,390 for you in gross profit. Given your single person status and your yearly gross income of $33,000, you would’ve owed the IRS 15% of your income or $4,950 and no tax on your stock gains had you waited another 2 months to sell your stock. However, since you sold your stock 10 months after buying it, your income is now assessed as $36,390 and this bumps you up to the 25% tax bracket. You now owe $9,097.50 on your total income, including tax on those capital gains. Your capital gains profit is gone and you’ve actually lost an additional $2,317.50 to boot.
Lesson learned here: Check which tax bracket your current earnings place you as well as how close you are located to the next bracket. Don’t sell any stock before its one year hold is up unless you are desperate for the money.
Dividends versus capital gains
Stock dividends are currently taxed as either ordinary or qualified dividends. Ordinary dividends are defined as dividends you collect from a domestic or foreign corporation that you hold for any length of time, even if that length of time is only a few hours. Such dividends are taxed at your current income tax bracket. Qualified dividends, meanwhile, are taxed at only 15% and are defined as being held “for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date,” according to IRS Publication 550. Thus, if you regularly “dividend poach” in order to gain a stock’s dividend before quickly selling it and buying the next dividend-bearing stock, be aware that you will be paying more for that advantage.
Lesson learned here: Stock poaching may not be the get-rich-quick scheme you had envisioned.
The outlook for 2013: You may need a stiff drink before reading this
Back in 2001 and 2003, the Bush tax cuts effectively lowered individual income tax brackets. These cuts were scheduled to expire by the end of 2011 but were extended until late 2012. With 2012 speeding to a close, there is worry that Congress will let these tax cuts expire and we’ll revert to our older and higher tax brackets. What does this mean for taxpayers? The chart below illustrates the differences between our current tax brackets and the older (and higher) ones:
|Tax Brackets (2012 Dollar Amounts)||Marginal Rate|
|Unmarried Filers||Married Joint Filers|
|Over||But Not Over||Over||But Not Over||2012||2013|
However, this isn’t all. Tax rates on long-term capital gains and all dividends will also increase if the Bush tax cuts are allowed to expire. Here’s the lowdown on upcoming long-term capital gains tax:
10% (up from 0%) if you are in the 15% tax bracket.
20% (up from 15%) if you are in any other tax bracket.
The exception to the 20% taxation rate would be if you had purchased dividend-bearing stocks after the year 2000 and held onto them for at least 5 years; your tax rate would be 18% and not 20%.
What about short-term capital gains tax?
Short-term capital gains have never been looked upon favorably by the IRS. In 2013, this disfavor will continue, with quickly gotten gains being taxed as ordinary income.
And ordinary and qualified dividends?
As opposed to having their own unique distinctions under the Bush tax cuts, both ordinary and qualified dividends will be taxed as ordinary income. So, if you’re going to poach, you may as well poach hard- at least if the pre-2001 tax rules come into play.
And yet more taxation (i.e., make mine a double)
As if all these raised (or reverted) taxes weren’t enough, high earners will be assessed an additional 3.8% Medicare (so-called ObamaCare) tax, bringing their total taxation rate to 43.4%. What qualifies as high? The IRS defines high as an adjusted gross income (AGI) of $200,000 or greater for single individuals and $250,000 or greater for those married and filing jointly. These amounts may seem big but they account for all kinds of income, including that derived from interest, dividends, passive income from business/trade, property gains and retirement plans. Thus, cashing in your 401(k) or IRA while you’re working may leave you with a nasty surprise come April.
Lessons learned here: Striving for long-term capital gains still allow you to keep more of your profits. Dividends, meanwhile, may bump you into the next tax bracket if you’re relying on them for the majority of your income. You may also be better off cashing in on your profitable investments and accounts this year instead of the next.
2013 may arguably be more challenging for investors- but not impossible. Sticking to long-term investments that pay regular dividends might be the best strategy until the new/old tax laws are settled. After all, even some passive income is better than no passive income. Meanwhile, keep your chin up and that flask handy. Besides, things could always be worse: just look at the proposed taxation levels in France!
There's only ONE program I really recommend. It helped me turn my 'hobby' into a $10,000+ per month money making machine. Click here for the exact formula I followed.