Tax implications

Dividends

Some funds pay ongoing dividends to shareholders. These dividends come from:

• Cash dividends received from equity securities (common and preferred stock)
• Interest received from debt securities

Income-based funds are the most likely to pay ongoing dividends. Growth funds tend to pay little or no ongoing dividends because many growth companies reinvest profits instead of paying 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 in order to distribute dividends to shareholders. Funds invested in dividend-paying common stock, preferred stock, and debt securities can generate that income. Growth funds invested in companies that don’t pay dividends generally won’t pay dividends to shareholders - there’s no income to pass through.

The tax rate paid on dividends is determined by an investor’s annual taxable income, which includes all of the following forms of income:

• Salary
• Wages
• Commissions
• Bonuses
• Royalties

The more income an investor earns, the higher their tax rate tends to be. Dividends can be qualified or non-qualified, which determines how they’re taxed. Qualified dividends are taxed at lower rates than non-qualified dividends (discussed below).

Qualified dividend tax rates

• 0% (low income)
• 15% (moderate income)
• 20% (high income)

Test questions relating to tax brackets tend to be generalized because these brackets change annually. Still, here’s a table with the specifics for investors filing single and married filing jointly (for tax year 2022):

Tax Rate	Individuals	Married filing jointly
0%	$0 - $40,400	$0 - $80,800
15%	$40,401 - $445,850	$80,801 - $501,600
20%	$445,851+	$501,600+

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 a bit bizarre and are 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.

To determine whether a mutual fund dividend is qualified, these requirements are applied to the fund’s underlying holdings.

For example, assume we’re discussing a value fund that holds only common stock. For a dividend paid to the fund’s shareholders to be qualified:

• The dividend income must come from US corporations or qualified foreign corporations, and
• The fund must meet the IRS-specified holding period

If those conditions are met, the dividend paid to shareholders is considered qualified.

If a dividend is not qualified, it’s taxed as a non-qualified (ordinary) dividend. The tax rate is the investor’s federal marginal income tax bracket. As of tax year 2022, these are the income tax brackets for individuals and those filing jointly:

Rate	Individuals	Married filing jointly
10%	$0	$0
12%	$10,276	$20,551
22%	$41,776	$83,551
24%	$89,076	$178,151
32%	$170,051	$340,101
35%	$215,951	$431,901
37%	$539,900	$647,851

Do not memorize these tax brackets; this chart is only for context.

Definitions

Marginal tax bracket

The tax bracket applied to the last dollar earned

Example: an individual making $50,000 would pay a 10% tax on the first $10,275 earned, a 12% tax on additional income up to $41,776, and a 22% tax on the remaining income received. Although the investor is taxed at 3 different rates, they are considered to fall in the 22% tax bracket.

The federal income tax rate an investor falls into determines the tax rate they pay on non-qualified dividends. In almost all cases, qualified dividends create a lower tax obligation.

For example, assume an individual earning $50,000 receives a $100 dividend:

• If the dividend is qualified, the tax rate is 15% (using the qualified dividend tax rate table above), so the tax is $15 ($100 x 15%).
• If the dividend is non-qualified, the tax rate is 22% (using the marginal income tax bracket table above), so the tax is $22 ($100 x 22%).

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, the interest would be taxed at a rate equal to their federal income tax bracket. The IRS treats the “pass through” of this interest via a non-qualified mutual fund dividend* the same way.

*Income paid out of a mutual fund is always considered a dividend, regardless of the source of income. For example, assume a bond fund receives interest from the bonds in its portfolio. When that income is then “passed through” to the fund’s shareholders, we call it a dividend.

Some dividend payments can be completely tax-free to any investor (regardless of tax bracket). In particular, a municipal bond fund invests in bonds that pay federally tax-free income. In addition, the income may be fully tax-free at the state level if the investor is a resident of the issuing 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.

• Cost basis is the purchase cost reported to the Internal Revenue Service (IRS).
• Sales proceeds are what you receive when you sell, after accounting for selling-related costs.

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 and then redeems them at $61 with a $1 redemption fee. The investor would report $60 in sales proceeds. Similar to cost basis, sales proceeds factor in transaction costs. The key difference is:

• Transaction costs are added to cost basis.
• Transaction costs are subtracted from sales proceeds.

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. If the shares were not sold, the investor would have an unrealized capital gain (a gain “on paper”). The IRS generally taxes gains only once they’re realized, which is why individuals with large unrealized gains can have low current tax bills.

At the end of each year, investors net their capital gains and losses to determine whether they owe taxes. Here’s 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 were the only trades during the year, the investor would have a $4,000 net capital gain (gains netted against losses). The investor would owe tax on the net gain. The tax rate depends on whether the gains were long-term or short-term.

Long-term capital gains are made on securities held for longer than a year. Technically, an investor needs to hold an investment for one year and a day to be considered 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. They are taxed at the investor’s income tax bracket, which could be as high as 37% (similar to non-qualified dividends).

What happens if there’s a net capital loss for the year? Let’s use the same figures, but change 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. Capital losses can reduce taxes. If an investor has a net capital loss for the year, they can deduct up to $3,000 of that loss against earned income that year. If this investor made $100,000 from their job, they could deduct $3,000 to bring taxable income to $97,000.

In this example, $10,000 of the $13,000 net capital loss is left over. Any leftover portion “rolls over” to the following year, which can offset future gains. In this example, the investor could realize $10,000 of capital gains in the following year and pay no taxes on those gains (because the rolled-over $10,000 capital loss offsets them).

Sidenote

Selling specific shares

When an investor sells shares accumulated over several purchases, deciding which shares are sold becomes important. Let’s assume an investor purchases $10,000 of the fund over a 3-year period, all at different prices per share (this is known as dollar cost averaging, which we’ll discuss in the next chapter).

Year	Purchase amount	Price per share	Shares purchased
2020	$10,000	$20	500
2021	$10,000	$25	400
2022	$10,000	$16	625

When the investor sells shares, they’ll need to determine which specific shares they sell (unless they sell all shares). Unless the investor requests a specific method, shares are sold on a first-in, first-out (FIFO) basis by default, meaning the oldest shares are sold first.

Let’s assume the investor sells 800 of their 1,525 shares at $30 per share using FIFO. In this example, they would be selling:

• 500 shares purchased at $20/share
• 300 shares purchased at $25/share

Next, the investor can find the overall cost basis by adding up the purchase amounts. They bought 500 shares for $10,000 in 2020 and 300 shares for $7,500 in 2021. This adds up to an average cost basis of:

• 800 shares purchased at $21.88

When the investor sells those shares at $30 per share, they lock in an overall $8.12 per share gain.

The investor could also opt to sell shares on a last-in, first-out (LIFO) basis, which sells the newest shares first. Again, assume the investor sells 800 shares at $30 per share. Under LIFO, they would be selling:

• 625 shares purchased at $16/share
• 175 shares purchased at $25/share

Let’s find their average cost basis. They bought 625 shares for $10,000 in 2022 and 175 shares for $4,375 in 2020. This adds up to an average cost basis of:

• 800 shares purchased at $17.97

When the investor sells those shares at $30 per share, they lock in an overall $12.03 per share gain

Last, the investor can use specific share identification, where the investor chooses which shares to sell. To minimize taxes as much as possible, the investor sells the most expensive shares first. Using this method, they’ll sell:

• 400 shares purchased at $25/share
• 400 shares purchased at $20/share

Let’s find their average cost basis. They bought 400 shares for $10,000 in 2021 and 400 shares for $8,000 in 2020. This adds up to an average cost basis of:

• 800 shares purchased at $22.50

When the investor sells those shares at $30 per share, they lock in an overall $7.50 per share gain.

Let’s compare all of the numbers:

Method	Gain per share
FIFO	$8.12
LIFO	$12.03
Specific share	$7.50

Of the three methods, specific share identification is the most tax-efficient here. The lower the reported gain, the fewer taxes the investor pays. Specific share identification allows investors to reduce their tax liability to the lowest possible level.

There is one last method of determining what shares are sold, but it is only available to mutual funds (not stocks or other securities). Known as average cost, single category (ACSC), this method uses a cost basis equal to the average of all shares purchased. Using the first table of this sidenote (above), the investor purchased 1,525 shares for a total of $30,000, resulting in an average cost of $19.67 ($30,000 / 1,525 shares).

Investors opting for ACSC are “locked in” after the first reported transaction. While investors are typically free to switch sales reporting methods (e.g. going from FIFO to LIFO), once ACSC is elected, it must be used until the position is completely liquidated.

Capital gain distributions

A fund investor can receive capital gains in two ways:

• The typical “buy low, sell high” capital gain when the investor sells fund shares
• A capital gain distribution paid by the fund

Fund managers invest client money and may actively trade within the portfolio. When a fund manager sells a security for a profit, the fund realizes a capital gain.

Capital gains realized inside the fund are often “passed through” to shareholders (we’ll learn why later in this chapter). If this happens, the investor receives a payment without selling their own fund shares, but they still owe tax on the distribution.

The tax status of the distribution (long-term or short-term) depends on how long the fund held the security before selling it. While funds can distribute short-term capital gains on any schedule, long-term capital gains may only be distributed once per calendar year.

Sidenote

Dividend yield

An investor can calculate a fund’s dividend yield by performing this calculation:

$\text{DY}=\frac{\text{Annual dividend income}}{\text{Current NAV}}$

For example, let’s assume the following:

ABC Fund

• Current NAV = $40
• Annual dividend = $3
• End-of-year capital gain distribution = $5

See if you can calculate the fund’s dividend yield.

(spoiler)

Answer = 7.5%

Here’s the calculation:

$\text{DY}=\frac{\text{Annual dividend income}}{\text{Current NAV}}$

$\text{DY}=\frac{\text{\$3}}{\text{\$40}}$

$\text{DY}=\text{7.5\%}$

If you didn’t get the right answer, it’s probably because you included the capital gain distribution in the calculation. Capital gain distributions can feel like income, but they aren’t considered dividend income. That’s why they aren’t included in dividend yield. This is a common exam trick.

Sidenote

Reinvestments & taxation

Many investors choose to reinvest dividend income and capital gain distributions instead of receiving them in cash. When this happens, the investor buys more shares and increases their position. However, reinvesting does not avoid taxes. A cash distribution (of any form) is generally taxable regardless of what the investor does with it.

Subchapter M

Subchapter M, also referred to as the “conduit rule,” allows investment companies and REITs to avoid taxation at the fund level. The conduit rule is an IRS rule that requires funds to distribute at least 90% of their net investment income to shareholders in order to qualify. In practice, most portfolios distribute roughly 98-99% of their investment income to shareholders by the end of the year.

By distributing income, the fund passes the tax obligation to shareholders, who then pay taxes on the income received. This structure helps protect the fund’s NAV. If the fund had to pay substantial taxes itself, the NAV would fall, reducing shareholder value.

Many investors will pay lower (or possibly no) taxes on the money received. For example:

• Many investors are in lower tax brackets than large funds, which can reduce the overall tax burden.
• Some investors hold mutual funds in retirement accounts, which are tax-sheltered. We’ll learn more about this in a future chapter. For now, assume investors do not pay taxes on returns in retirement accounts.

Funds that follow Subchapter M are called “regulated” funds. Regulated funds can pass taxable income through to shareholders.

Real Estate Investment Trusts (REITs) are also subject to Subchapter M, with additional requirements. As long as REITs pass through at least 90% of net investment income to investors, the REIT can avoid paying taxes on that income (taxes are paid by the investor instead). In addition, REITs must have 75% of their assets invested in real estate and 75% of their income come from real estate investments to qualify.

Subchapter M (conduit rule) for REITs

• To qualify:
  • 75%+ invested in real estate
  • 75%+ income from real estate
  • 90%+ net investment income distributed

Key points

Cash dividends

• Taxable income received from stock or mutual fund investments

Qualified dividends

• Tax rates
  • 0% (low income)
  • 15% (moderate income)
  • 20% (high income)
• To be considered qualified:
  • Distributed by a US corporation or qualified foreign corporation
  • The investor must meet a specific holding period

Non-qualified dividends

• Tax rate equal to federal marginal income tax bracket (up to 37%)

Capital gain

• Securities sold for more than the basis
• Subject to capital gain taxation

Capital loss

• Securities sold for less than the basis
• Provides a tax deduction

Long-term capital gain

• Gain on security held more than 1 year
• Tax rate: 0%, 15%, or 20%

Short-term capital gain

• Gain on security held for 1 year or less
• Tax rate: up to 37% (income tax bracket)

Selling security shares or units

• Investors can utilize FIFO, LIFO, or specific share identification
• Specific share identification results in the lowest tax liability

Average cost, single category

• Shares reflect the average cost for tax reporting
• Only available to mutual funds
• Investors are “locked in” to this method once utilized

Subchapter M

• Tax regulation for certain securities
• Taxable income passed to investors
• Also known as the “conduit” rule
• Must pass 90% of net investment income to qualify