Stock vs Bonds, tax comparison, Part 1

Stocks and Bonds are the most common investment options, each has its own tax characteristics.

In this post, I'll primarily discuss the tax liabilities of stocks.

People make money from stocks through two methods, price increase (appreciation) and dividend. Both are fairly intuitive. You buy low, you sell high, then you have appreciation, in IRS's books, it's called capital gain. Companies pay their shareholders part of the earnings, and that's dividend.

Price appreciation, or capital gain, is taxed differently depending on how long you hold the stocks for. If shares of a stock is sold within 1 year of the purchase date, whatever you gain is categorized as short-term capital gain, which means the tax rate is exactly the same as your marginal ordinary income tax rate. In my case, that's 28% federal tax + 9.3% state tax. Ouch, more than a third of what I make is going to the government! Even though I don't hate the government, I don't like it too much either, not so much that I'm willing to part with 37.3% of my investment earnings. On the other hand, if shares of a stock is held for more than 1 year and then sold, it is taxed according to the rules of long-term capital gain, at a much more favorable rate of 15% federal + 9.3% state (I know, sucks to be in California, many other states differentiate between long-term and short-term capital gains though).

Conclusion here is that Uncle Sam loves buy and hold investors more! (I'm sure it loves everyone none-the-less, LOL)

Some caveats here:

1. That 15% LT capital gain tax can change, and in fact, it's scheduled to increase to 20% starting January 2013. Moar tax plz...
2. Many of us invest through mutual funds, myself included. The taxation for mutual funds are slightly more complex than individual stocks. In the eyes of IRS, what you are buying is not "THE FUND", you are buying individual stocks in some proportion. That proportion is dictated by the fund manager, and can change over the course of a year, sometimes drastically. Every time when this proportion changes differently than the prices of each individual stock, your fund manager is essentially selling / buying stocks on your behalf. And that is a taxable event, which follows the tax rules I described above. When you sell the fund, of course, that's another taxable event, because in essence you are selling every individual stocks that you own through that mutual fund. Therefore, when you select funds, it probably makes sense to pay attention to what's known as "turn-over rate", a number that measures how much the manager has traded in a year. 0% means the manager never exchanged any shares, and 100% means none of the shares that the fund had at the beginning of a year has remained at the end of that year (read: probably a lot of tax). Index funds usually have close to 0% turn-over, and actively-managed funds tend to be a lot higher. But don't just shy away from actively-managed funds, because if they offer much better returns such that earning - tax is higher than the index fund, it makes perfect sense to buy actively-managed funds. How you determine how much a fund will return in a year, is a completely different matter though.

Now dividends also have two categories since IRS loves complexity. Those "qualified" dividends are basically all the dividends that you get from U.S. companies. They are taxed identically to LT capital gain. Those "non-qualified" dividends, are mostly foreign company dividends, some banking accounts' "dividends" (interests really) , and pretty much anything that is not included in the lonely qualified category. They are treated the same way as ST capital gain (read: a lot of tax). 

If you choose to employ a dividend-oriented investment strategy, i.e. buying shares of stable companies that pay high dividends, such as Microsoft, it then makes sense to stick to U.S.-based companies, because otherwise you'll get hit pretty heavily with non-qualified dividend tax. 

Assuming you are in the 28% tax bracket, here is a summary table for you:

Type	Long-term Capital Gain	Short-term Capital Gain	Qualified Dividend	Non-qualified Dividends
Applicable to	Share price appreciation when held for more than 1 year	Share price appreciate when held for less than a year	Dividends paid by U.S. companies	Any other kind of dividend
Tax rate	15%	28%	15%	28%

We discussed the "gain" situation in this post, as we know, stocks go down too, and they can go down by a lot, which means the "loss" situation is equally important. Luckily, the IRS is pretty fair when it comes to losses during an investment. I'll write out what I know in the next post.