Tax considerations
Dividends
Some funds pay ongoing dividends to their shareholders, which represent the cash dividends received from equity securities (common and preferred stock) and/or interest received from debt securities. Income-based funds are most likely to pay ongoing dividends, while growth funds tend to pay little, if no dividends. Here are two real-world examples:
Franklin DynaTech Fund (Ticker: FKDNX)
- Invests in growth tech companies
- Rare for stocks in the fund’s portfolio to pay dividends
- Has not paid a dividend since 2001*
*Although this fund has not paid a dividend since 2001, it typically makes a capital gain distribution annually to shareholders. We will discuss capital gain distributions below.
Franklin High Yield Fund (Ticker: FVHIX)
- Invests in junk (high yield) bonds
- Bonds in the fund pay high coupon (interest) payments
- Fund distributes monthly dividend payments to investors
Bottom line - a fund must receive income to distribute dividends to shareholders. This occurs with funds invested in dividend-paying common stocks, preferred stocks, and debt securities. However, growth funds invested in companies that do not pay dividends will not pay dividends to shareholders -there’s no income to pay!
The tax rate paid on dividends is determined by an investor’s annual taxable income, which includes all of the following:
- Salary
- Wages
- Commissions
- Bonuses
- Royalties
The more income one makes, the higher the investor’s tax rate. Dividends can be qualified or non-qualified, which relates to how they’re taxed. Qualified dividends are taxable at lower rates than non-qualified dividends (discussed below). Here’s a breakdown:
Qualified dividend tax rates
- 0% (low income)
- 15% (moderate income)
- 20% (high income)
Test questions relating to tax brackets tend to be generalized as these brackets change annually. Regardless, here’s a table with the specifics for investors filing single and married filing jointly (for the tax year 2024):
| Tax Rate | Individuals | Married filing jointly |
|---|---|---|
| 0% | $0 - $47,025 | $0 - $94,055 |
| 15% | $47,026 - $518,900 | $94,056 - $583,750 |
| 20% | $518,901+ | $583,751+ |
Do not memorize the specifics; this chart is only for context.
For a cash dividend to be qualified, it must meet two general requirements imposed by the IRS:
- Distributed by a US corporation or qualified foreign corporation*
- The investor must meet a specific unhedged** holding period***
*To be considered a qualified foreign corporation, it must meet any one of the following requirements:
- Incorporated in a US possession (including territories like Puerto Rico)
- Subject to a US tax treaty
- The dividend-paying security trades on an established stock exchange (e.g. an American Depositary Receipt trading on the NYSE)
**Unhedged means unprotected. An unhedged position does not have any insurance or another related product that would prevent the investor from a loss.
***The holding periods established by the IRS are bizarre and unlikely to be tested (knowing a holding period requirement exists for a dividend to be qualified should suffice). For example, the holding period for common stock dividends requires the stock to be held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.
The requirements listed above are checked against the underlying securities in the mutual fund to determine if a dividend is qualified. For example, let’s assume we’re discussing a value fund with only common stock in the portfolio. For a dividend paid to investors out of the fund to be qualified, the disbursement must originate from US or qualified foreign corporations, plus the fund must meet the IRS-specified holding period. If so, the dividend paid to the fund’s shareholders will be considered qualified.
If a dividend is not qualified, it will be taxed as a non-qualified (ordinary) dividend. The applicable tax rate equals the investor’s federal marginal income tax bracket. This is likely the tax you’re most aware of, as it typically represents the most significant obligation for a taxpayer. As of the tax year 2024, these are the income tax brackets for individuals and those filing jointly:
| Rate | Individuals | Married filing jointly |
|---|---|---|
| 10% | $0 | $0 |
| 12% | $11,601 | $23,201 |
| 22% | $47,151 | $94,301 |
| 24% | $100,526 | $201,051 |
| 32% | $191,951 | $383,901 |
| 35% | $243,726 | $487,451 |
| 37% | $609,351 | $731,201 |
Do not memorize these tax brackets; this chart is only for context.
The federal income tax rate an investor falls into determines the tax rate they pay on non-qualified dividends. Qualified dividends always result in a lower tax obligation. For example, let’s assume an individual making an annual salary of $50,000 receives a $100 dividend. If the dividend is qualified, they face a 15% tax rate (using the qualified dividend tax rate table above), resulting in a $15 tax obligation ($100 x 15%). If the dividend is non-qualified, they face a 22% tax rate (using the marginal income tax bracket table above), resulting in a $22 tax obligation. Obviously, investors prefer qualified dividends over non-qualified dividends.
Dividends paid out of certain funds are always considered non-qualified. For example, dividends paid out of mutual funds holding US government and/or corporate debt securities. If an investor held these bonds directly, they would pay a tax rate on the interest equal to their federal income tax bracket. The IRS treats the “pass-through” of this interest via a non-qualified mutual fund dividend* similarly.
*Income paid out of a mutual fund is always considered a dividend, regardless of the source income. For example, assume a bond fund receives interest from the bonds in its portfolio. When the interest is “passed through” to the fund’s shareholders, we call it a dividend.
Some dividend payments can be entirely tax-free (regardless of tax bracket). In particular, a municipal bond fund invests in debt securities that pay federally tax-free income. Additionally, the income could be entirely tax-free if the investor is a resident of the municipality. For example, an investor residing in California would receive tax-free dividends from the Putnam California Tax Exempt Income Fund* (Ticker: PCIYX).
*This fund invests primarily in California municipal bonds, which pay tax-exempt income to investors residing in California.
Capital gains
Capital gains occur when a security’s sales proceeds exceed its cost basis. When an investor purchases a security, the overall cost is reported to the Internal Revenue Service (IRS) as the “basis.” Let’s assume an investor purchases shares of ABC Fund at a public offering price* (POP) of $50. Their reported cost basis would be $50 per share.
*Cost basis includes any transaction fees. Therefore a fund with a NAV of $49 and a sales charge of $1 would result in both a $50 POP and $50 cost basis. The same goes for stocks, bonds, or any other security. For example, a stock purchased for $75 with a $1 commission would result in a $76 cost basis.
The investor holds the ABC Fund shares for a while, then redeems the shares at $61 with a $1 redemption fee. The investor would report $60 in sales proceeds. Similar to cost basis, sales proceeds factors in transaction costs. The only difference is that transaction costs are subtracted from sales proceeds, but are added to the cost basis.
Let’s summarize what just occurred:
Cost basis = $50
Sales proceeds = $60
Total capital gain = $10
The $10 capital gain was realized when the security was sold. Had the shares been left unsold, the investor would have an unrealized capital gain (a.k.a. a gain “on paper”). The IRS only taxes investors once gains are realized, which is how uber-wealthy individuals like Jeff Bezos can get away with paying little-to-no federal taxes. While he’s worth more than $150 billion, most of his assets are tied up in Amazon stock. He only gets a tax bill when he sells shares!
At the end of each year, investors must net out their capital gains and losses to determine if they owe taxes. Let’s work through an example:
January 30th
- Sold ABC fund for $2,000 capital gain
March 15th
- Sold BCD fund for $5,000 capital gain
July 10th
- Sold CDE fund for $3,000 capital loss
If these three transactions were the only trades placed during the year, the investor ends up with a $4,000 net capital gain (gains are netted against losses). The investor must pay a tax on the net gain. Of course, the tax rate depends on whether the gains are long or short-term.
Long-term capital gains are made on securities held for longer than a year. An investor must hold an investment for one year and a day to be long-term. Long-term capital gains are taxed similarly to qualified dividends - at a rate of 0%, 15%, or 20% (review above for the details).
Short-term capital gains are made on securities held for one year or less. Short-term capital gains are taxed at the investor’s income tax bracket, which could be as high as 37% (similar to non-qualified dividends). Obviously, investors prefer long-term capital gains because they’re taxed at lower rates.
What happens if there’s a net capital loss for the year? Let’s use the same figures, but tweak the July 10th trade.
January 30th
- Sold ABC fund for $2,000 capital gain
March 15th
- Sold BCD fund for $5,000 capital gain
July 10th
- Sold CDE fund for $20,000 capital loss
The investor now ends with a $13,000 net capital loss. Losing money on an investment is never fun, but capital losses reduce taxes paid by investors. If an investor has a net capital loss for the year, they can deduct up to $3,000 of the capital loss against earned income that year. Assuming this investor made $100,000 from their job, they could deduct $3,000 to bring their taxable income to $97,000. The deduction results in a lower tax obligation.
In this example, $10,000 of the $13,000 net capital loss is leftover. Any leftover portion “rolls over” to the following year, which helps the investor avoid taxes on future gains. The investor could make $10,000 of capital gains next year and not pay any taxes (the rolled-over $10,000 capital loss offsets it).
Capital gain distributions
Technically, a fund investor can obtain two types of capital gains - the typical “buy low, sell high” capital gain, and a capital gain distribution. Fund managers are tasked with investing their clients’ money and sometimes even actively trade in the fund portfolios. When a fund manager sells a security and locks in a profit, they realize a capital gain.
Capital gains made within fund portfolios are often “passed through” to investors (we’ll learn why later in this chapter). If this occurs, the investor receives payment without selling their own fund shares. Additionally, they will pay tax on the capital gain. The tax status of the capital gain (long or short-term) is determined by how long the fund held the security before the sale. While funds can distribute short-term capital gains on any schedule, long-term capital gains may only be distributed once per calendar year.
Subchapter M
Subchapter M, also referred to as the “conduit rule,” allows funds to avoid taxation. This IRS rule requires funds to distribute at least 90% of their net investment income to shareholders to qualify. In reality, most funds distribute upwards of 98-99% of their investment income to shareholders by the end of the year. Funds that engage in Subchapter M are called regulated funds.
By doing so, the fund passes the taxation to shareholders, who are now subject to paying taxes on the income received. It may seem unfair, but it’s best for everyone. Remember, shareholders benefit when a fund performs well. If the fund is required to pay substantial taxes, the NAV of the fund will decline, causing the investor to lose value (taxes would be paid out of the fund’s assets).
Many investors will pay lower or no taxes on the income received. First, most investors will be in lower tax brackets than large funds. Additionally, some investors own mutual funds in their tax-sheltered retirement accounts. We’ll learn more about this in the retirement plans chapter. For now, it’s okay to assume investors do not pay taxes on returns in retirement accounts.
Tax forms
Dividends are reported on the tax form 1099-DIV annually. Brokerage firms send these forms to their customers and the IRS. The form details dividends received and their status (qualified or non-qualified). For a dividend to show up on a given year’s 1099-DIV form, it must be paid in that year. If a dividend were declared in 2023 but paid in 2024, it would be reported on 2024’s 1099-DIV form.
Similarly, interest received from debt securities is reported on tax form 1099-INT. Interest is reported on a given year’s tax forms only if it was received in that calendar year.
Capital gains are reported on form 1099-B (B stands for brokerage proceeds). Every year, brokerage firms report their customers’ capital gains and losses. If the investor has more gains than losses (net capital gain), they will owe taxes. As discussed above, a net capital loss can be used as a deduction.
Inherited securities
Death is an unfortunate aspect of life, but the IRS tries to make grieving easier by reducing tax burdens on inherited securities. In particular, two tax-beneficial things occur:
- Cost basis is “stepped up”
- The holding period is automatically long term
When an investor dies, their assets are passed on to their beneficiaries. The new cost basis of the security reflects the value on the day of the original owner’s death. Also, the holding period for the inheritor is long-term, regardless of how long the original owner held the investment. To better understand this, let’s assume the following:
An investor purchases $100,000 of XYZ Stock Fund on January 10th, 2022. The investor dies on June 10th, 2022 when the position was valued at $140,000. The shares are inherited by the investor’s daughter, who redeems the shares for a total of $150,000 July 1st, 2022.
Although the position initially established a cost basis of $100,000, it is “stepped up” to $140,000 upon the original owner’s death. The step up reduces taxation considerably. With a total liquidation value of $150,000, the daughter locks in a taxable gain of $10,000 with the step-up ($140,000 cost basis vs. $150,000 sales proceeds). If the step-up didn’t occur, the inheritor would’ve reported a $50,000 taxable gain ($100,000 cost basis vs. $150,000 sales proceeds). Additionally, the gain is long-term, although the shares were only held roughly six months.
Assuming the inheritor is at the 32% tax bracket, let’s look at the difference in tax liability:
With inheritance tax rules
- Cost basis = $140,000
- Sales proceeds = $150,000
- $10,000 realized long term capital gain
- $10,000 gain x 15% (long term gain rate) = $1,500 tax liability
Without inheritance tax rules
- Cost basis = $100,000
- Sales proceeds = $150,000
- $50,000 realized short term capital gain
- $50,000 gain x 32% (short term gain rate) = $16,000 tax liability
As you can see, the inheritance tax rules can significantly reduce tax liability. Instead of paying a 32% tax (tax bracket applies to short-term gains) on a $50,000 gain, the inheritor only pays a 15% tax on a $10,000 gain, resulting in tax savings of $14,500.
Gifted securities
Unlike inherited securities, gifted securities are not eligible for tax benefits. The original owner’s cost basis transfers directly to the person receiving the securities. Additionally, the holding period does not adjust. To better understand this, let’s use the same example above (adjusted to be a gift):
An investor purchases $100,000 of XYZ Stock Fund on January 10th, 2022. The investor gifts the fund shares to their daughter on June 10th, 2022 when the position was valued at $140,000. The daughter liquidates the shares for a total of $150,000 July 1st, 2022.
In this case, the daughter retains the original cost basis of $100,000 and the short-term holding period.
- Cost basis = $100,000
- Sales proceeds = $150,000
- $50,000 realized short-term capital gain
- $50,000 gain x 32% (short term gain rate) = $16,000 tax liability
Wash sales
A wash sale occurs if an investor sells a security at a loss and repurchases it within 30 days of the original sale. This rule prevents investors from selling investments to lock in a deductible capital loss, only to repurchase it immediately or quickly after. For example:
January 20
- Investor purchases 100 shares at $50
March 15
- Investor sells 100 shares at $20
- Realized loss of $30 per share ($3,000 overall)
March 16
- Investor buys 100 shares at $20
Although the investor sold their shares at a loss, they repurchased the shares the next day. Nothing significant occurred except for the $3,000 realized loss, which is deductible. The IRS feels this encourages investors to sell securities at a loss and repurchase them to obtain tax benefits. To prevent it from commonly occurring, the wash sale rule was created and imposed on security transactions. The basics of the rule are:
- Capital losses are disallowed if security is repurchased within 30 days of the sale
- Disallowed loss is added to the cost basis of the new position
Let’s run through an example:
An investor purchases 100 shares of MNO Fund at $50 per share on February 10th. On April 20th, the shares are sold for $28 per share. On May 5th, the investor buys 100 shares of MNO Fund at $30.
In this example, the investor locks in a $22 per share loss on April 20th, resulting in an overall $2,200 deductible capital loss. 15 days later, the investment is repurchased for $30 per share. The $22 per share loss is disallowed and cannot be used for a tax deduction.
The loss doesn’t completely evaporate, though. The disallowed loss is added to the cost basis of the new position, which helps reduce potential taxes when the investment is sold again. Although 100 new shares were purchased at $30, the investor will reflect a cost basis of 100 shares at $52 per share ($30 + $22 disallowed loss). If the investor were to sell their shares at the $30, they would reflect a $22 per share loss ($30 sales proceeds vs. $52 cost basis). If the investor doesn’t repurchase the shares again within 30 days, they can keep the $22 per share loss.
The wash sale rule applies to repurchases of the same security, or even a similar security. The IRS refers to these as “substantially identical securities.” For stock, this includes:
- Convertible securities
- Rights*
- Warrants*
- Options
*Rights and warrants are derivative securities that provide the right to buy stock at a fixed price. Other than discussing their impact on wash sales, we do not expect you to encounter any Series 6 test questions on these securities. If you’re curious, you can review their characteristics on the Achievable Series 7 program.
If a security provides an easy way to obtain the stock (through converting or exercising), it’s considered the same as buying the actual stock. For bond wash sales, it’s a bit different. If an investor repurchases a bond within 30 days of selling a bond at a loss, they can avoid the wash sale rule if two of the following three items on the new bond are different:
- Coupon
- Maturity
- Issuer
The 30-day wash sales period applies before and after the loss is realized. This prevents investors from “front-loading” shares. For example:
An investor purchases 100 shares of AXP Fund at $90 per share on August 20th. On October 1st, 100 more shares of AXP Fund are purchased at $76. The next day, the shares are sold for $73 per share.
Before selling their shares at a loss, the investor purchased an additional 100 shares. On October 2nd, they sell the original 100 shares (assuming FIFO; see below additional information on FIFO) for a $17 loss ($73 sales proceeds vs. $90 cost basis). Additional shares were purchased the previous day, within the 30-day wash sale period. Therefore, the $17 loss is disallowed and added to the cost basis of the current position. The investor now reflects a $93 per share cost basis ($76 cost basis + $17 disallowed loss). If they sell these shares later, they can keep any realized loss as long as they do not repurchase the shares again within 30 days of the sale.
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