Understand Investment Return Taxation to Make Well-Informed Financial Decisions

In investment management, a solid understanding of the tax implications is indispensable for making well-informed financial decisions. The income generated from various investments can fall into distinct categories, each subject to its own unique tax treatment. This article is designed to broadly discuss investment return taxation, while covering a range of topics, including the types of income, basis, capital gains and losses, holding periods, taxable income considerations, and the strategic use of capital losses.

At First Bank Wealth Management, we encourage clients to seek professional tax guidance when dealing with complex tax scenarios.

Recognize Diverse Income Streams:

Ordinary income encompasses a broad spectrum of earnings derived from investments, including interest income, rent, returns from savings accounts, certificates of deposit, money market accounts, annuities, bonds, and certain preferred stock. This income is typically subject to taxation at standard income tax rates. Tax-Exempt Income relates to certain investments, such as Roth IRA’s, municipal bonds, and U.S. Treasury securities, offering income that is exempt from federal and/or state income tax. Tax-Deferred Income, on the other hand, relates to income on gains in tax-deferred accounts, such as 401(k) retirement plans and traditional IRA’s that are taxed at a later date.

Understand Basis:

The initial basis of an asset usually mirrors its purchase cost, but it can vary when an asset is received as a gift, inheritance, or through a tax-free exchange. The adjusted basis is a dynamic figure that can change over time due to factors like improvements made to a real estate asset. The treatment of capital gains and losses is pivotal in investment taxation.

Here are three key considerations regarding basis:
  1. A capital gain arises when the sale price of an asset surpasses its adjusted basis.
  2. A capital loss is incurred when the sale price falls below the adjusted basis.
  3. Different tax rates apply to short-term and long-term capital gains.

Learn The Importance of Holding Periods:

The duration for which you hold an asset holds the key to taxation. It determines whether a capital gain is considered short term (held for a year or less) or long term (held for over a year). Long-term capital gains often enjoy more favorable tax rates in contrast to short-term gains.

Understand Capital Gain Taxation:

The extent of your taxable income has a direct bearing on how capital gains and qualified dividends are taxed. Special capital gains tax rates, varying from 0%, 15%, to 20%, are applied based on your taxable income. Additionally, some type of capital gains may be taxed as high as 28%.

Harness Capital Losses:

Capital losses can be a potent tool for mitigating tax liabilities stemming from capital gains. Essential considerations include utilizing carried forward losses to offset future capital gains if they are not used to offset gains in the current year. This feature allows you to tap into capital losses from preceding years to minimize your tax obligations when capital gains arise in subsequent years. Additionally, an allowable deduction of up to $3,000 in capital losses is permitted against ordinary income ($1,500 for married individuals filing separately).

Seek Counsel for Professional Assistance:

Given the intricate nature of investment taxation, it is prudent to contemplate professional guidance for convoluted tax scenarios. While Internal Revenue Service (IRS) publications and tax references offer valuable insights, seeking counsel from a certified accountant or tax professional is especially advantageous when dealing with complex investment transactions and intricate tax planning.

If you have any questions or concerns, please reach out to your First Bank Wealth Management Team.
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Ron Manning is a Portfolio Manager II for First Bank Wealth Management. With over 20 years of experience in financial services and a deep knowledge of investment portfolio management across both traditional and alternative asset classes. You may contact Ron Manning at (925) 746-2800 or via email at [email protected].