Taxes on Investment Returns

Kavan Choksi Briefly Discusses the Impact of Taxes on Investment Returns


A balanced and diversified portfolio typically includes a combination of tax-free, tax-advantaged and fully taxable investment vehicles and investment accounts. Kavan Choksi mentions that the makeup of an investment portfolio shall majorly impact the overall tax burden of an investor, and hence it is critical that they consider the big picture. Typically, investments having a longer horizon can help investors to lower their tax bills.

Kavan Choksi sheds light on the impact of taxes on varying types of investments

Fully taxable investment vehicles like stocks, bonds, mutual funds and ETFs do not receive preferential tax treatment. Investors have to pay taxes on the income they earn through capital gains, dividend distributions and interest. However, there is no limit as such how much one can invest. A dividend distribution an investor receives from stocks generally is taxable. This rate may vary depending on the dividend type. Nonqualified dividends are taxed at the ordinary income tax rate, while qualified dividends are taxed at a lower rate on the basis of the filing status and taxable income, and are capped at 20%. In case one sells off their shares, they would be taxed on capital gains. The capital gains rate tends to vary on the basis of how long the person has held the stock. Interest earned on bonds, with the exception of municipal bonds, are essentially taxed as ordinary income.

As mutual funds are made up of a number of investment securities like bonds and stocks, capital gains and dividends on them depend on certain specific factors. These factors include how long a fund has held an individual investment in the portfolio rather than how long the investors have owned shares of the mutual fund. Mutual funds typically pay the distribution on accrued income, whether interest or divided, in the form of dividends. They might also pay a distribution for the capital gains incurred within the investment tool. Kavan Choksi points out that these are taxed based on the type of investments that make up the mutual fund, as well as the qualifications of the investment account and the investor. As a person sells their position, they shall be taxed on the capital gains accrued in the holding. ETFs Exchange-traded funds (ETFs) also act in a manner similar to mutual funds when it comes to taxes. However, distributions are just accrued on dividend/interest income in this situation, and not on capital gains owing to the way they have been structured. This makes a few ETFs more tax-efficient than mutual funds.

Investments that are tax-deferred, tax-exempt or provide some other type of tax benefits are referred to as tax-advantaged. Municipal bond funds are one such popular investment tool. This asset can be purchased individually or included as a part of a mutual fund or an ETF. Choosing to pool multiple municipal bonds into a single fund allows the investors to put their money in a variety of bonds. Municipal bonds are usually exempt at the federal level, and even at the local and state level, if the investor lives in the state in which the bond was issued. However, in case they buy bonds issued in another state, they might be taxed on the interest income by their home state.

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