The wise investor has a wide and diverse portfolio. There are many complexities to investments, and you need to be aware and engaged with every decision and factor that can affect your portfolio and holdings. Taxes play no small role in this. Risk-averse investors will tend to hold much of their portfolios in "income investments," which are investments with less emphasis on growth in value and more of a focus on paid interest or dividends. However, just because this investment is risk-averse, it doesn’t mean it is risk-free. It’s important to be aware of the different tax treatments when managing your income investments.
The Value of Qualified Dividends
The taxation of investment income varies depending on whether the income is in the form of dividends or interest. Qualified dividends are taxed at the favorable long-term capital gains tax rate, which is currently 0%, 15%, or 20%, depending on your tax bracket. Unqualified dividends are currently taxed at the ordinary-income tax rate, which might be as high as 39.6%. Interest income is also generally taxed at ordinary-income rates. Therefore, we know that stocks that pay dividends might be more attractive tax-wise than interest-paying income investments, such as CDs and bonds. Filling your portfolio with qualified dividends will provide benefits come tax time.
Exceptions to the Rule
However, there are exceptions to the rule. For example, some dividends aren’t qualified, and therefore, are subject to ordinary-income rates, such as certain dividends from:
- Real Estate Investment Trusts (REITs)—a type of security that invests in real estate through property or mortgages
- Money market mutual funds—an investment whose objective is to earn interest for a while maintaining a net value asset of $1 per share
- Certain foreign investments
The Taxation of Interest Received on Bonds Also Differs:
- Interest on U.S. government bonds is taxable on federal returns but exempt on state and local returns.
- Interest on state and local government bonds is excludable on federal returns. If the bonds were issued in your home state, interest also might be excludable on your state return.
- Corporate bond interest is fully taxable for federal and state purposes.
Keep in mind that current and future tax reform legislation could affect the tax considerations for income investments. For example, if your ordinary rate goes down under tax reform, there could be less of a difference between the tax rate you’d pay on qualified vs. nonqualified dividends. This change in the taxation rates may give you flexibility in your portfolio and holdings to seek out new types of investments.
Remember that you are in the driver’s seat with your investments. Choose your destination, and enjoy the ride. The price you pay on taxes shouldn’t influence your decisions when it comes to income investments, but it is helpful and productive to know. Contact our experienced financial planners at 952.893.9320 or email@example.com for help factoring taxes into your investment strategy.
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Boulay PLLP and Boulay Financial Advisors, LLC are separate entities from ValMark Securities, Inc. and ValMark Advisers, Inc. Prime Global is not affiliated with ValMark Securities, Inc. and ValMark Advisers, Inc.
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