Tax implications

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 ongoing 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 some form of income to distribute dividends to shareholders. This will occur 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 forms of income:

• 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 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 if a dividend is qualified, the requirements listed above are checked against the underlying securities in the mutual fund. For example, let’s assume we’re discussing a value fund with only common stock in the portfolio. In order 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 is equal to the investor’s federal marginal income tax bracket. This is likely the tax you’re most aware of, as it typically represents the largest obligation for a taxpayer. As of the 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 will 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 were qualified, they face a 15% tax rate on the dividend (using the qualified dividend tax rate table above), resulting in a $15 tax obligation ($100 x 15%). If the dividend were non-qualified, they face a 22% tax rate on the dividend (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, the 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 simply treats the “pass through” of this interest via a non-qualified mutual fund dividend* in the same manner.

*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 now 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. Additionally, the income could be fully 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 cost 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 any transaction costs. The only difference is transaction costs are subtracted from sales proceeds, while they are added to 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 considers taxing 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 find out 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 trades 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 would be required to 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. Technically, an investor needs to hold an investment for one year and a day in order 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 a security is never fun, but capital losses reduce taxes paid by investors. If an investor has a net capital loss for the year, they are able to deduct up to $3,000 of the capital loss against earned income that year. If 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 paying fewer taxes overall.

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. In this example, the investor could make $10,000 of capital gains in the following year and not pay any taxes on the gains (the rolled-over $10,000 capital loss offsets it).

Sidenote

Selling specific shares

When an investor sells shares they’ve accumulated over several trades, deciding what shares are sold becomes an important perspective. 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 as a default, meaning the oldest shares are sold first. Let’s assume the investor sells 800 of their 1,525 shares at $30 per share and uses this method. In this example, they would be selling:

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

Next, the investor can find their overall cost basis by adding up the numbers. 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 $(10000+7500)/(500+300)=17500/800=21.875$:

• 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 would sell the newest shares first. Again, let’s assume the investor sells 800 shares at $30 per share and find the overall gain using this method:

• 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 also utilize a method called specific share identification, where the investor chooses which shares to sell specifically. To minimize taxes as much as possible, the investor will sell 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 now:

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

Of the three methods, specific share identification was the most tax efficient. Remember, the lower the reported gain, the fewer taxes the investor pays. Specific shares identification always 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 simply reflects 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

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 the job of 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 oftentimes “passed through” to investors (we’ll learn why later in this chapter). If this occurs, the investor receives payment without having to sell 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 security was held by the fund 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.

Sidenote

Dividend yield

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

$\text{DY}=\frac{\text{Annual dividend\hspace{0.33em}income}}{\text{Current NAV}}$

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:

$\text{DY}=\frac{\text{Annual dividend income}}{\text{Current\hspace{0.33em}NAV}}$

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

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

If you didn’t get the right answer, it’s probably because you included the capital gain distribution in the calculation. While they feel like dividend income, capital gain distributions are not considered income. Therefore, they are not included in this calculation. Be careful - this is a common trick used on the exam!

Sidenote

Reinvestments & taxation

Many investors choose to reinvest dividend income and capital gain distributions instead of simply receiving these funds in cash. When this occurs, the investor purchases more shares and increases their position. However, it does not allow the investor to 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. The conduit rule is an IRS rule, which requires funds to distribute at least 90% of their net investment income to shareholders in order to qualify. In reality, most portfolios distribute upwards of 98-99% of their investment income to shareholders by the end of the year.

By doing so, the fund passes on the taxation to its shareholders, who are now subject to paying taxes on the income received. This 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 fall, causing the investor to lose value.

Many investors will pay lower or possibly no taxes on the money received. First, most investors will be in lower tax brackets than large funds, effectively allowing fewer taxes overall to be paid. Additionally, some investors own mutual funds in their retirement accounts, which are tax-sheltered. We’ll learn more about this in a future chapter. For now, it’s okay to assume investors do not pay taxes on returns in retirement accounts.

Funds that engage in Subchapter M are called “regulated” funds. Regulated funds are able to pass on their taxable income to their shareholders, which saves money for everyone.

Real Estate Investment Trusts (REITs) are also subject to Subchapter M, but there are some added layers. As long as REITs pass through at least 90% of the net investment income to their investors, the fund can avoid paying taxes on that income (taxes are paid by the investor instead). Additionally, 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 “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